Mahoshada

The economic record of 2005 ended on a positive note with the Central Bank’s announcement on December 30th that GDP growth during the third quarter (July through September) was higher than expected, 6.4 percent – as compared with the same three months in 2004. Not surprisingly, the government did what it could to take a “glass is half full” approach in publicizing the news, quite rightly too. Higher growth is, or ought to be, one of the country’s highest economic priorities. Unless the growth rate increases to something on the order of 8 to 10 percent and maintains that pace for a number of years, it will be virtually impossible to make much significant progress in reducing poverty and substantially improving the standard of living of all Sri Lankans. So, any sign of an increasing growth rate is to be welcomed.

But, (there is always a ‘but’), there are two questions we should be asking with regard to this news. What was responsible for this increase in the growth rate? And… Are conditions changing in ways that would allow us to reasonably expect continued higher growth at rates even higher than 6.4 percent?

Sources of Growth
The Central Bank reports GDP growth numbers for the entire economy and also by key sectors and subsectors (industries). The growth rate for the entire economy is simply an average of the growth rates of all the different industries taking place during the period. Some of these have been growing at relatively low rates while others have reported much higher rates. By looking at how the different parts of the economy performed we can get a better idea of which areas were sufficiently fast growing to pull up the aggregate rate up to 6.4 percent.

When we look at these more detailed numbers, it is apparent that the third quarter increase in growth was largely due to several exceptional dynamic industries. As usual there were also a few activities doing moderately well while much of the rest of the economy languished.

Agriculture: Overall the agriculture and fisheries sector grew at 2 percent, which was a marked improvement over the previous three quarters – from October 2004 through June 2005 – when the sector reported negative growth rates, in other words, was contracting. (Over the last 13 quarters, since July 2003, nearly half of the time the agriculture sector reported negative growth.)

In reality it is unlikely that in its current state, agriculture will be able to contribute much to the country’s overall economic growth. While there is scope for substantially improving productivity – and sectoral growth – progress will be very difficult as long as farm sizes remain far too small to make profitable use of available improved technologies, including greater mechanization. The long term trend in almost all developed countries has been a major shift from numerous small farmers to many fewer larger farms. This process has been spurred not by any social or political desire – but entirely as a response to the much improved technologies that have become available. Indeed, most governments have to some degree resisted the reduction in the numbers of farmers, but in the face of strong underlying economic forces, this resistance has largely been futile.

Industry: The industrial sector grew at 6.9 percent during the third quarter – led by the mining subsector, which grew at a remarkable 34.9 percent, due in large part to the strong and growing demand for mineral sands and phosphate.

Manufacturing itself grew by 5.7 percent during the quarter; with agricultural processing activities showing strong growth, including tea and rubber processing as well as rice milling, reflecting the increased agricultural output.

However, the key apparel industry showed a continuing decline in growth since the beginning of the year and the end of the Multi-Fibre Arrangement (MFA). During the third quarter, the growth rate in apparel production fell to 4.7 percent – down from more than six percent during the first half of the year. It is clear that while the worst case post-MFA scenario was wrong, the industry did not collapse overnight, it is clear that a difficult road lays ahead for this major source of exports and employment. And it has also become clear that quick fixes, such as the EU’s GSP+ and the temporary special access to the US market, are unlikely to change this picture very much over the long term. As one person in the business recently remarked about the business environment that producers face, “it is increasingly becoming an impossible situation.”

Services: It has been the services sector that has been driving the economy forward. Third quarter growth was estimated at 7.5 percent, largely due to the 34 percent growth rate in the telecommunications industry. Recall that it was during the third quarter that there was the rapid expansion of wireless services such as CDMA began in earnest. This section of the business grew by 73 percent. (In contrast, fixed line services grew by only 6.5 percent.)

This should not be surprising because the telecommunications subsector has recently emerged as one of the country’s most dynamic and competitive industries. Does anyone think that this would be the case today if the government had not privatized the SLT in the 1990s and also took steps to reduce the burden of regulation? Yet this message seems to have been missed by many in the current government – particularly the JVP who strive to hold the line against further privatizations. Wouldn’t it be nice to be able to look forward to an equally dynamic and competitive power sector in five or ten years time?

The tourism industry (hotels and restaurants) showed a major reduction in activity during the third quarter – by 30.6 percent – despite the fact that the number of tourist arrivals was more or less the same. This paralleled a similar decline in the number of nights spent by foreigners in hotels.

And of course the public sector – government – continued to grow strongly, at 5.8 percent, attributable in part by the increased employment of graduates at the end of 2004. This illustrates one of the pitfalls in equating GDP growth with real improvements in economic performance. By most accounts the government has had great difficulties in finding meaningful work for many of these graduates to do. It is well known that virtually all government departments were already greatly over-staffed anyway. By hiring an unemployed graduate and paying him or her a salary does not automatically mean that they make a comparable contribution to the real value of goods and services produced nationally, even though the GDP data seem to say this. It may ‘look’ like growth, but it is not necessarily economic progress.

Changing Mindset
It is worth keeping in mind that as of 2004, the agriculture sector, including fisheries, contributed less than 18 percent of total national value added (GDP). There continues to be a tendency to think of agriculture as the mainstay of the country’s economy. That is no longer the case. The industrial sector, also widely viewed as another economic mainstay, contributed another 27 percent, barely more than one-quarter of total GDP. Together agriculture and industry account for less than one-half of economic activity, of only about 45 percent.

Today the services sector is in fact the mainstay of the economy – accounting for 55 percent of total national value added. It is also the more dynamic and competitive part of the economy and is likely to generate much of the additional investment that will take place in the coming years. The significant investment by an international bank in late 2003 to set up an offshore support centre here was hopefully only the first of many of service related investments.

It is important for policy makers as well as the general public to move from a mindset that views the heart of the economy as mainly comprising agriculture and industry – which produces “things”, to an appreciation of the fact that the future is going to increasingly be based on producing services. But to create an environment where there can be many different telecom-type industries growing rapidly will require movement on privatization as well as a less restrictive policy and regulatory environment with more competition from domestic as well as foreign firms.

The much respected publication from the Heritage Foundation, The Index Economic Freedom 2006, was released last week and the picture for the country is not very bright. (The entire book can be downloaded for free at www.heritage.org.) Sri Lanka was ranked 92 out of 157 countries, or somewhat below the middle of the pack. In fact, Sri Lanka was among the 10 countries whose standing in the index deteriorated the most in 2006. With regard to the regulatory environment, this is what the report had to say:

“Sri Lankan regulations can be difficult to decipher, in addition to which enforcement can be deficient and transparency is sometimes lacking. The US Department of Commerce reports that ‘some of the laws and regulations are not freely available and are difficult to access. Foreign and domestic investors often complain that the regulatory system allows far too much leeway for bureaucratic discretion…’ The bureaucracy often employs cronies and is subject to corruption. The Economist Intelligence Unit reports that ‘labour laws are archaic and the sacking of employees requires permission of a labour commission.’”

What is Ahead?
It has to be noted that while security issues are raising major concerns about the current quality of the economic environment, there have recently been several positive steps in the government’s management of the economy. Inflation is gradually coming down somewhat and the gap between inflation and interest rates is narrowing. However, the expanding deficit for 2006, 9.1 percent, may undermine in the coming year what little progress that has so far been achieved.

Given the strong third quarter growth, it is likely that GDP growth for the year will indeed fall in the 5 to 5.5 percent range predicted by the Central Bank. But while it is always nice to be on the mark when making forecasts, the government should not be patting itself on the bank for this result. The Sri Lankan economy has shown over long years that almost no matter how bad things get, either politically or with the war, it can consistently manage to squeeze out 4 to 5 percent growth rates. But this performance has failed to make any serious inroads in terms of reducing poverty or improving living standards generally. And it should not be forgotten that while third quarter growth at 6.4 percent is a bright spot, the growth rate for the first nine months of 2005 – 5.5 percent – was actually lower than for the same nine months in 2004 – 5.8 percent.