Mahoshada

This month marked the publication of the 12th Index of Economic Freedom by the Heritage Foundation and the Wall Street Journal. This has become one of the most influential of the annual scorecards of economic conditions prevailing in countries around the world. This year 161 countries were included and scores were based on 50 variables that were organized into ten broad categories.

Why are the results presented in the Index of Economic Freedom important for policy makers and the general public in Sri Lanka? Perhaps the most compelling reason is that the Index does help to shape the views of potential investors. The Index is important because lots of people think it is important, and pay at least some attention to it.

An example of the growing influence of the Index is the fact that the United States’ Millennium Challenge Corporation (MCC), a potential major source of financial assistance to the country, is using the Index in establishing countries’ eligibility for assistance. It is reported that the MCC could provide Sri Lanka with as much as $500 million in grant assistance, (grants, unlike loans, do not have to be repaid). Sri Lanka is currently among those countries eligible for MCC assistance, but that could change if reforms are not adequately pursued or there is backsliding. Consider that when the MCC announced in November that Yemen was being suspended from being eligible for assistance, among the criteria cited was an increasingly closed trade policy environment – based on the measures provided in the Index.

But why do so many people pay attention to the Index? Quite simply, after more than a decade of examining this analysis, it is clear that countries that maintain high degrees of economic freedom do much better than those that do not. There is a very high relationship between economic freedom and levels of average incomes.

The Index is also a good indicator of which countries are improving their economies and which are allowing economic conditions to deteriorate. There is a strong relationship between a country’s year to year changes in economic freedom and its economic growth rate. A country that is improving year after year, despite still having a relatively low overall score, is far more likely to be growing more rapidly and also a more desirable location for investors than one where the score is falling.

2006 Global Results
The Index of Economic Freedom calculates a score, between 1 and 5, for all countries. As mentioned above, this is based on 50 different economic, social and political variables. In 2006, of the 161 countries examined, there were 20 countries that received the top grade and were deemed to be “free” while 52 countries did reasonably well and were seen as being “mostly free”. The largest group included 73 countries, which were graded as “mostly unfree”, a group that includes Sri Lanka. At the bottom of table, there were 12 countries described as “repressed” and 4 for which reliable information could not be obtained.

The top two countries are Hong Kong and Singapore, both of which have long maintained free trade policies – virtually zero tariffs. They have also kept regulatory burdens on businesses to a minimum. Other countries in the top ten include Ireland, Luxembourg, Iceland, UK, Estonia, Denmark, Australia, New Zealand and the US. It is worth pointing out that in this group, Estonia, Ireland and Australia all showed major increases in economic freedom compared with their scores in 1995. Indeed, even Hong Kong, which was among the top ranked countries in 1995, has also shown a substantial improvement over the last decade.

2006 Results for Sri Lanka
Sri Lanka was ranked 92nd which put the country in the “mostly unfree” group; tied with Romania and just above Djibouti, Kenya and Tanzania. In the 2005 Index, Sri Lanka was ranked 79th, with a score that put the country very close to returning to the “mostly free” group of countries for the first time since 2002.

This sharp drop in the country’s score for economic freedom and its fall in relative ranking translated into Sri Lanka being among the ten countries with the worst performance over the last year. (Sri Lanka was 8th worst while Iran was the worst overall.) There were three broad areas that helped the country earn this rather dubious distinction: (i) capital flows and foreign investment; (ii) trade policy and (iii) fiscal burden of government.

Briefly, the poorer score regarding capital flows and investment was due to continuing restrictions limiting foreign investment. A report by the US Trade Representative was cited, which said “Investment in additional sectors is restricted and subject to screening and approval on a case-by-case basis when foreign equity exceeds 40 percent.” The WTO reported that “foreign and domestic investors often complain that the regulatory system allows for too much bureaucratic discretion…. Foreign inflows have remained subdued … due to factors including obstacles to clearing products through customs, lack of access to land to build factories, and inadequate infrastructure.”

Despite the frequent assertions by officials that the country maintains one of the most free and open national environments for investment, perceptions among many existing and potential investors are very different. These are typical of often heard complaints that undoubtedly have much validity. And by appearing in the Index of Economic Freedom, these views will only gain further credibility.

The lower score for trade policy reflects the increase in average tariffs that took place in 2004; a rise from 4.2 percent in 2001 to 6.8 percent in 2004. The WTO was cited as saying that the country’s trade policies suffered from “overlapping jurisdictions in trade and trade-related policies leading to a lack of coherence in their formulation and implementation… Non-tariff barriers, especially licenses affect a substantial number of goods.” In fact, if other taxes and barriers to trade were taken fully into account, such as the cesses on imports that have been introduced by the current government, it is likely that the country would have scored even lower.

The Index scored Sri Lanka slightly lower with regard to the fiscal burden of government largely because of the continued high deficit and the slower reduction in government expenditures in 2001 and 2002. However, it is important to note that the higher increase in government expenditures since 2004 have yet to make themselves felt in the Index. When these appear in the coming years, the country’s score will fall even further.

So what?
These rather dismal results should alert the government, the private sector and the general public alike that the sense of complacency with regard to pursuing meaningful economic reforms that seems to have been the order of the day since the UPFA government assumed office in 2004 will have important economic consequences. The government may be able to mislead some of the public with a lot of lofty rhetoric about introducing a national economic model that will bring prosperity to the masses, especially in the rural areas. But, as they say, talk is cheap.

It is now nearly two years since the UPFA assumed office and despite the various policy statements that have been issued, the numerous committees that have been established and the workshops that have been organized, no serious attempts at genuine economic reform have taken place. Instead, politically driven – but economically wasteful – government expenditure has grown, diverting resources that are needed to invest in the country’s economic capacity. As a result, the country’s economic performance has amounted to little more than muddling through, largely on the underlying strength of a few key private sector industries.

What many politicians seem to overlook is the fact that it is more than just the local voters they have to convince – the rest of the world is watching and making their own assessment of the economic conditions here. Many other countries are actively implementing key economic reforms with a goal of improving performance and attracting increased foreign investment. Even a number of Sub-Saharan African countries are making important strides. It is a very competitive race to succeed in an increasingly competitive global economy – and it is getting tougher all the time. Standing still will not suffice.

It is worth noting that for the last two years Pakistan has made major improvements in its standing in the Index. This year they are the country that has shown the greatest increase in the overall score. Last year, 2005, they were second best. As a result, over the last year they jumped from 133rd to 110th – 23 places. This was while Sri Lanka was falling 13 places. If this trend continues, Pakistan will surpass Sri Lanka next year.

A Roadmap
In addition to demonstrating where the country stands relative to the rest of the world, these international score cards also provide a useful roadmap for policy makers and the public about what needs to be done. If one looks examines the detailed standing according to the different variables, it is clear what the reform priorities ought to be.

The 2006 Index of Economic Freedom, which runs to 440 pages, can be downloaded without charge at www.heritage.org.