This Selected Issues paper on Sri Lanka reviews several issues that highlight both Sri Lanka’s accomplishments and their policy constraints amidst a protracted period of civil conflict and political instability. High intermediation costs have held back development of the financial sector and could also frustrate Sri Lanka’s quest for higher growth. The main constraints to achieving higher growth include the civil conflict, political instability, high fiscal deficits and inflation, and underdeveloped financial markets.

Abstract

This Selected Issues paper on Sri Lanka reviews several issues that highlight both Sri Lanka’s accomplishments and their policy constraints amidst a protracted period of civil conflict and political instability. High intermediation costs have held back development of the financial sector and could also frustrate Sri Lanka’s quest for higher growth. The main constraints to achieving higher growth include the civil conflict, political instability, high fiscal deficits and inflation, and underdeveloped financial markets.

I. Economic Growth in Sri Lanka: Record and Prospects1

A. Introduction

1. This chapter reviews Sri Lanka’s economic growth record over the last 25 years and analyzes the factors underpinning this performance. In doing this, it identifies the impediments that will have to be removed to raise Sri Lanka’s growth rate over the medium term. The main constraints to achieving higher growth are: the civil conflict, political instability, high fiscal deficits and inflation, underdeveloped financial markets, misguided agricultural policies, inadequate infrastructure, and labor rigidities.

B. Sri Lanka’s Growth Experience

2. Since the late 1970s, when a policy shift toward a more liberal economic regime took place, Sri Lanka’s real GDP growth has averaged 4¾ percent a year. Sri Lanka’s growth rate in per capita terms—at 3½ percent—has been approximately the same as in India and higher than in Pakistan, Bangladesh, and Nepal (Table I.1). On average, low-income countries and lower-middle income countries have not performed better over the same period. In particular, of a group of countries with similar income per capita in the mid-1970s, only Botswana did better.2 However, a number of East Asian economies, such as China, Korea, Thailand and Singapore, outperformed Sri Lanka by a wide margin. As a result of this divergence, for instance, Thailand’s GDP per capita in 2003 was two times Sri Lanka’s while the difference in 1975 was only 30 percent.

Table I.1.

Growth Performance of Selected Asian and World Economies by Income Level, 1978¬2003

(Annual averages)

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Source: World Development Indicators, World Bank, 2005.

3. Over the years, trend economic growth has fluctuated with the pace of economic reforms and the intensity of the civil conflict (Figure I.1)

Figure I.1.
Figure I.1.

Sri Lanka: Annual Real GDP Growth, 1979¬2004 (In percent)

Citation: IMF Staff Country Reports 2005, 337; 10.5089/9781451972542.002.A001

  • The first wave of liberalization paid handsomely with private investment doubling to 21 percent of GDP and growth rising above 6 percent in 1978–1982.

  • When simmering ethnic tensions, however, developed into full-scale civil war in 1983, private confidence took a severe blow and the government focus of attention shifted away from economic reforms. GDP growth declined to an average of 33/4 percent in 1983–89.

  • Despite the continuation of the civil conflict, a pickup in reforms in the first half of the 1990s raised average growth to 5½ percent.

  • While reform efforts lost steam, the war escalated following a brief ceasefire and an attempt at peace talks in 1995. In 2000, higher oil prices and large imports of military equipment brought the country to the brink of a foreign exchange crisis and the following year, hit by a terrorist attack on the Colombo airport, political instability, a severe drought, and the global slowdown, the economy suffered its first recession in decades. The average growth from 1995 to 2001 fell below 4 percent.

  • The ceasefire that has held since 2002 to date has contributed to the pickup in growth above 5 percent in 2002-04 despite the lack of progress in the peace process. At the same time, political instability has hampered the implementation of structural reforms.

4. In terms of sectoral contributions to growth, agriculture has been a continued drag, and services have gradually replaced manufacturing as the most dynamic sector. The long-term average growth rate in agriculture has barely exceeded the rate of population growth, which has contributed to the persistence of poverty (the headcount ratio stood at 23 percent in 2002, which is relatively high for Sri Lanka’s per capita income).

Manufacturing was the main source of growth during the 1990s, when the apparel industry took off (Table I.2). In the 2000s, the expansion in telecoms (largely fulfilling pent-up demand for fixed line and cellular telephone services) has made the largest contribution to growth while more recently port services have grown strongly. Both of these sectors—telecoms and ports—have benefited from deregulation and privatization in recent years.

Table I.2.

Sri Lanka: GDP Growth by Sector, 1983¬2004

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Sources: Central Bank of Sri Lanka; and IMF staff estimates.

5. A growth accounting exercise suggests that total factor productivity (TFP) was an important factor behind the increased growth rates in the first half of the 1990s.3 The expansion of manufacturing, where productivity is almost twice as high as in agriculture, is one of the main factors underlying this result. Large increases in investment rates (public and private) and the very low initial capital output ratio explain the large contribution of capital accumulation to growth in the late-l970s. In the 1980s, the slowdown was broad based although the pace of capital accumulation remained relatively rapid as a result of public investments in irrigation. In recent years the ceasefire has resulted in an expansion of trade among Sri Lankan provinces and increasing employment. Many new jobs, however, have been created in sectors of relatively low productivity, such as agriculture, which pulls down the estimates of TFP growth (Table I.3).

Table I.3.

Sri Lanka: Growth Accounting Decomposition

(Annual average; in percent)

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Sources: CBSL Annual Report (various issues); and IMF staff estimates.

C. What Factors Explain the Growth Performance?

6. A vast literature on growth and development provides useful guidance in identifying the main factors underpinning Sri Lanka’s growth performance. The evidence on conditional convergence implies that the relatively low starting income levels in the 1970s helped Sri Lanka enjoy a higher growth rate (Barro and Sala-i-Martin, 2003). Among other variables that have been found to be associated with higher growth, Sri Lanka has enjoyed a relatively favorable position on human capital development and some aspects of governance (Table I.4).

Table I.4.

Selected Indicators of Human Capital Development and Governance1/

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Sources: World Bank, 2005, World Development Indicators and Governance Research Indicators.

By construction, governance indicators around the world have approximately a normal distribution with zero mean and unit standard deviation.

  • Human capital development. At 67 years in the mid-1970s, life expectancy in Sri Lanka was higher than in Thailand, Malaysia, Korea or China, and roughly the same as the average in upper middle-income countries. Estimates in the growth literature (Barro and Sala-i-Martin, op. cit.) suggest that a 10-year difference in life expectancy (which is less, for instance, than the difference between India and Sri Lanka in the mid-1970s) is associated with more than a 1 percentage point difference in growth rates of per capita GDP as a longer and healthier life increases the incentives for investment in human capital. The most recent data confirm that Sri Lanka still compares favorably with this group of countries. The comparison is equally favorable in terms of literacy rates, which were above 80 percent in the mid-1970s and now exceed 90 percent. On measures of human capital development, Sri Lanka is well ahead of most other South Asian economies.

  • Some aspects of governance. Sri Lanka scores relatively well in a set of indicators compiled by Kauffman et al. (1999 and 2005) related to quality of regulation, the rule of law, and control of corruption.4 These authors have provided empirical evidence of a strong casual relationship from better governance to better development outcomes, including higher income levels. Comparisons are clearly favorable when taken with other South Asian economies along the first two dimensions. In terms of control of corruption, the differences between Sri Lanka and India are not statistically significant but both countries are well ahead of Bangladesh and Pakistan. Indicators for Sri Lanka are in line with China’s and Thailand’s.

7. In contrast, the following factors have hampered Sri Lanka’s growth performance:

  • The civil conflict. The civil conflict has affected economic growth through several channels, most clearly through the loss of human lives and the destruction of property and infrastructure. It has also absorbed a large amount of manpower and physical equipment that could have been used more productively in other activities. In particular, government spending on defense rose by more than 2 percent of GDP during the conflict years compared with pre-war levels. Staff estimates suggest that an increase in annual investment by 2 percent of GDP could have raised GDP growth by 0.4 percent a year.5 Higher costs of doing business—for instance, on transportation and insurance premiums as well as a result of the general disruption of economic activity—also lowered total factor productivity and the incentives to invest. The conflict had the largest impact on certain economic activities (e.g., tourism) and geographical areas (the North and East and the areas bordering this region). For instance, tourist arrivals, which had reached 400,000 in 1982, fell to 150,000 in the late 1980s and only recovered to the pre-war level in 2003 after the ceasefire was signed. In a more indirect way, the conflict has also affected the ability of successive governments to concentrate on economic reforms.

  • Political instability. According to the widely used International Country Risk Guide (ICRG) political risk rating, of more than 130 countries, less than fifteen were perceived to be more unstable than Sri Lanka from 1984 (the first year for which the index was compiled) to 1995—Bangladesh and Pakistan were among them (Figure I.2). In part, political instability has been intimately related to the civil conflict, and fueled by political assassinations.6 On the other hand, political instability related to the government’s inability to implement its policy agenda or as policy uncertainty also appears to have been a concern, especially in recent years. After a large improvement in 2002 following the ceasefire agreement, the ICRG index of political instability has worsened gradually to a level in 2004 equivalent to the average of the index for 1996–2000. This has reflected the lack of progress on the peace process but also the weakness of successive governments, which have been unable to implement their policy agenda, and the lack of a broad consensus on economic reforms. Policy uncertainty was identified in a recent ADB/World Bank business climate survey as the second most important factor affecting the competitiveness of Sri Lanka (Figure I.3).

  • High fiscal deficits and inflation. Fiscal deficits have averaged close to 91/2 percent of GDP from the mid-1970s until 2004. Very few countries have averaged higher fiscal deficits than Sri Lanka over the last 25 years. High deficits have raised the level of public debt to more than 100 percent of GDP, hampering private investment by raising expectations of higher future taxes and heightening macroeconomic risks. Interest payments have become the largest expenditure item in the government budget and have crowded out public investment. Indeed, the ADB/WB business survey identified the risk of macroeconomic instability as an important burden on the investment climate while poor transport infrastructure was singled out as the single most important constraint by rural firms. Fiscal dominance of monetary policy has also contributed to a relatively high average inflation rate of more than 10 percent. Estimates in Batista and Zalduendo (2004) suggest that lowering inflation from 10 to 5 percent could increase GDP growth rates by about 1/4 percentage point by improving resource allocation.

  • Underdeveloped financial markets. Typical measures of financial depth suggest that Sri Lanka remains relatively underdeveloped.7 The corporate bond market also remains very thin and most firms rely on internally generated funds or bank credit to finance investment. The dominance of public sector institutions in the financial system (state-owned banks, savings banks, and pension funds) has hampered financial market development as banks remain relatively inefficient and other institutions have mostly been used as captive sources of government financing.

  • High electricity tariffs and labor market rigidities. These factors have also been identified in the ADB/WB business survey as major constraints for private investment. Given the dependence on oil for electricity generation, reflecting years of underinvestment, and operational inefficiencies at the Ceylon Electricity Board, including large transmission losses, electricity tariffs are high (Rs. 7–7.5 per kilowatt for industrial users) although they remain well below cost recovery levels. In the labor market, redundancy decisions are subject to approval by the labor commissioner, who until 2003 also had discretion over the amount of redundancy payments. In practice, these were set at very high levels (2–3 months of wages per year worked). Since then, a formula for redundancy payments has been introduced, adding predictability, but redundancy costs remain among the highest in the world.8

  • Misguided agricultural policies. Agricultural policies, primarily aimed at attaining self sufficiency in paddy production, have constrained the diversification into higher yield crops. Restrictions on the transfer and use of land have also prevented the consolidation of small plots into larger economically viable holdings. The development of land markets would facilitate access to credit by allowing the use of land as collateral. Lack of access to credit has been identified as a top constraint for the development of rural firms (World Bank, 2005). High and variable import tariffs for agricultural commodities has also led to price distortions and discouraged investment in storage facilities (as protection is usually lowered when domestic prices rise).

Figure I.2.
Figure I.2.

Selected Countries Political Risk Ratings, 1984¬2004 (Scale 0 to 100, a higher index implies less risk)

Citation: IMF Staff Country Reports 2005, 337; 10.5089/9781451972542.002.A001

Source: International Country Risk Guide, PRS Group.
Figure I.3.
Figure I.3.

Sri Lanka: Investment Climate Survey, 2004 (In percent of firms identifying indicator as a major obstacle to business)

Citation: IMF Staff Country Reports 2005, 337; 10.5089/9781451972542.002.A001

Source: World Bank.

D. Looking Ahead

8. While comparing favorably to many countries at a similar stage of development, Sri Lanka’s growth performance has trailed the fast growing countries of Southeast Asia. This chapter suggests that Sri Lanka has benefited from relatively good levels of human capital development and governance. However, many other factors have constrained Sri Lanka’s growth performance: the civil conflict, political instability, high fiscal deficits and inflation, inefficiencies in the financial and energy sectors, which are dominated by the public sector, and overly regulated land and labor markets.

9. Sri Lanka’s medium term macroeconomic framework assumes that GDP growth will rise above its historical average to 6–7 percent a year. The fact that only on one occasion since 1950 Sri Lanka has enjoyed growth above 6 percent for two years in a row underscores that this is an ambitious goal. Achieving it will require major changes in the investment environment and in the macroeconomic policies that have hampered economic growth. In particular: a durable solution to the civil conflict will have to be reached; the fiscal deficit and inflation reduced, while increasing spending on infrastructure; the political environment will have to improve and a broad consensus on the policies that have to be sustained over time needs to be developed; and structural reforms in the electricity sector, financial sector, the labor market and the agriculture sector that relax the constraints highlighted in the previous section have to be implemented. In the absence of reforms, growth performance could remain below 5 percent.

  • Barro, Robert and Xavier Sala-i-Martin, 2003, Economic Growth, Second Edition, October (Boston, Masschusetts: MIT Press).

  • Batista, Catia and Juan Zalduendo, 2004, “Can the IMF’s Medium-Term Growth Projections Be Improved?,” IMF Working Paper 04/203, October (Washington: International Monetary Fund).

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  • Central Bank of Sri Lanka, Annual Reports, various years. Available via the Internet: www.centralbanklanka.org.

  • Heston, Alan and Robert Summers, 1991, “The Penn World Table (Mark 5): An Expanded Set of International Comparisons, 1950–1988,” Quarterly Journal of Economics, pp. 327368 (May).

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  • Kauffman, Daniel, Aart Kraay and Pablo Zoido-Lobaton, 1999, “Governance Matters,” World Bank Policy Research Working Paper 2196, October (Washington).

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  • Kauffman, Daniel, Aart Kraay and Massimo Mastruzzi, 2005, Governance Matters IV: Governance Indicators for 1996–2004, May (Washington: World Bank).

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  • World Bank, 2005, Sri Lanka Development Forum: The Economy, the Tsunami and Poverty Reduction, May (Washington).

1

Prepared by Enric Fernandez.

2

Of the other eight countries with income per capita (in purchasing power terms) within 20 percent of Sri Lanka’s in the mid-1970s, Zambia, Madagascar, and Central African Republic contracted; Gambia, Senegal, Mauritania and Solomon islands grew by 0-l percent a year; and Egypt grew by 2¾ percent a year.

3

For the growth accounting exercise, a time series for the capital stock was estimated using the perpetual inventory method with national accounts data on investment and an estimate for the capital-output ratio in 1960 from the Penn World Tables, version 5.6 (Summers and Heston, 1991). Data on employment is from annual reports of the Central Bank of Sri Lanka and were interpolated for years with missing observations. The share of capital in total income and the depreciation rate were assumed to be 40 percent and 8 percent, respectively. No adjustment was made for the quality of inputs.

4

These indicators are based on a variety of surveys measuring subjective perceptions of various aspects of governance and have been available since 1996. The indicators for 1996 are taken here as a proxy for governance over the period for which the GDP growth is being analyzed.

5

Assuming a Cobb-Douglas production function with constant returns to scale, the marginal product of capital is equal to the product of the capital share (assumed to be 0.4, as in the growth accounting exercise) and the inverse of the capital-output ratio (estimated to be around 1.85 during the civil conflict years).

6

For instance, the 1990’s witnessed the assassinations of President Premadasa and Presidential candidate Dissanayake in 1993 and 1994 respectively, and the attempted assassination of President Kumaratunga in 1999.

7

In Sri Lanka, stocks traded, private sector credit, and broad money were about 3 percent, 30 percent and 40 percent of GDP, respectively, in 2004. The average for lower middle income countries is above 20 percent, 70 percent, and 80 percent of GDP, respectively (World Development Indicators, 2005).

8

In 2005 the ceiling for redundancy payments was raised to 48 months of wages, compared to 31.5 months under the previous formula. Benefits accrue at a rate of 2.5 months of wages per year worked during the first four years; 2 months of wages per year worked during the next 5 years; and so on, declining to 0.5 months of wages per year worked during years 28 to 37. Thus, a worker who is laid off after 20 years of employment would be entitled to 36 months of wages.

Sri Lanka: Selected Issues and Statistical Appendix
Author: International Monetary Fund
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    Sri Lanka: Annual Real GDP Growth, 1979¬2004 (In percent)

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    Selected Countries Political Risk Ratings, 1984¬2004 (Scale 0 to 100, a higher index implies less risk)

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    Sri Lanka: Investment Climate Survey, 2004 (In percent of firms identifying indicator as a major obstacle to business)