Mahoshada

“We’ve put everything on hold”, said an executive from one multinational country. “What can you do with this much uncertainty? Better to sit it out for now.”

The above quote was included in an article published by Reuters, titled “Sri Lankan Fighting Puts Investment on Ice” that appeared in newspapers and in online news outlets worldwide several days ago, (including the 18th August edition of the daily edition of The Island). The article went on to say that shops were ordered closed in Tricomalee and Vavuniya and in the East. It also reported that tourism related businesses in the deep South were also being adversely affected, quoting one local businessman who had rebuilt his restaurant in Unawatuna as saying “Who will come if there is war? I wouldn’t! I won’t even go to Colombo these days.”

This very negative international assessment of the changing investment climate has the potential to damage the country’s future economic prospects. Sri Lanka is competing with other countries in the region and around the world for vitally important but very limited international investment – investment in productive capacity essential to generate employment and sustain economic growth. And we should not lose sight of the fact that investment that is lost today is effectively lost forever. It is not simply deferred until a time when the investment climate improves. Missed investment means that the country’s productive capacity will be permanently lower than it would be otherwise; and as a result, the people of Sri Lanka will be poorer.

We should also not make the mistake in thinking that it will be only foreign investors that are deterred by the economic uncertainty that comes with the return to war. Sri Lankan investors face the same sort of decisions as do foreign businesses. They too aim to find the best possible returns for their investments, wherever that might be. Although there are laws and regulations in place that seek to make it more difficult for Sri Lankans to move their resources offshore and invest in other countries, these restrictions have never been very effective. There are simply too many ways for investors seeking more certain higher returns to get around these barriers.

The impact of an increasingly uncertain economic environment will almost certainly also lead to a diversion of resources away from productive investment in other ways. People here have the option of holding their savings in unproductive assets such as gold or foreign currency, a traditional hedge against economic uncertainty. As the international businessman quoted above suggested, many will find it better to sit it out for now. The fall in the demand for shares and the sagging values of equities traded on the Colombo Stock Exchange suggest that many see investing in local business activities as increasingly risky.

The impact of the resumption of the war on the investment climate can also be seen in the negative assessments by international ratings agencies. Earlier this year both Standard and Poor’s and Fitch reduced their credit ratings for Sri Lanka to “junk” or “below investment grade”. Whether the recent escalation of the violence and the adverse impacts of the bombings in Colombo will lead to further reductions in Sri Lanka’s credit rating depend on how investors respond to the deteriorating situation and how the government handles what will likely be increasing fiscal pressures as the cost of the growing conflict.

Looking for Positive Signs?
Not surprisingly, the government and others are trying to paint a very different picture concerning economic conditions. Officials are citing the high growth figures reported earlier in the year as a sign that the economy is healthy and performing well. They point to the strength of the country’s principal export industries, garments and tea, as well as to high expectations for continued recovery in the tourism sector. For example, this week the Media Minister was reported as saying that local hotels have solid bookings, suggesting that tourists are unconcerned with the increasing reports of violence and terrorism. The minister was quoted by LBO as saying “Hotels in Colombo are full. … I don’t think the violence has caused any big impact on the economy. The hotels are having a blast.” Despite the minister’s possibly unfortunate choice of words, this may be only a very short term assessment reflecting more the start of the South Asian games and not taking into account South Africa’s withdrawal from the one-day cricket tournament underway.

And the fact is that in the more than two decades that the country has had to contend with the ethnic conflict, the economy has managed to maintain a moderate rate of growth throughout. There can be no doubt that local business people have learned over the years how to manage to get by in very difficult circumstances. Some might argue that this past experience indicates that the Sri Lankan economy will be largely impervious to the impacts of a resumption of war. Will the Media Minister be right, that the increased violence will not have a “big impact on the economy”?

Reasons to be Cautious
While in some respects the economy today is stronger than was the case in years past, when the country had to contend with a significant, sustained military conflict, there are also greater vulnerabilities in at least some respects.

The economy is more susceptible today to external factors than it was previously. Key sectors on which economic performance depends face more competitive international market conditions. For example, garment manufacturers no longer have virtually guaranteed markets since the end of the MFA and must now contend with the enormous competitive pressures from China and other countries. This industry has had a difficult time making the adjustment to a post-MFA world in the last two years. Many producers have been finding it difficult to survive even with the semblance peace provided by the ceasefire agreement. International buyers will be less likely to be willing to accept the risks associated with producers in a country facing the prospect of full scale war. The tourism sector is equally vulnerable. There are today more countries competing vigorously for tourists’ business as tourists seemingly become more sensitive to prospects of encountering acts of terrorism in their travels. The industry must also contend with the increasing costs of air travel as world oil prices continue to remain high. Evidence of this increasing sensitivity to external factors can be seen in the unprecedented downturn in the economy that took place in 2001, after the attack at the airport and 9/11.

The country’s fiscal condition is also less sound. The government has continued to run high budget deficits for many years now, driving public debt up to around 100 percent of GDP. By accumulating high levels of debt, the capacity of the country to borrow to meet an upsurge in military related expenditures will be diminished. Any substantial increase in borrowing is likely to come with more stringent terms. And in part because the government has been resorting to “printing money” to finance their high budget deficits, the inflation rate has remained relatively high (e.g., at 10.4 percent for the month of July).

Reflecting this, there are concerns in the financial community regarding the implications of resumed hostilities. A local analyst was quoted this week on LBO as saying, “If the violence escalates, like the two recent bomb attacks in Colombo city, the government will have to spend more on defence and put pressure on the balance of payments this year.”

The scope for the government to substantially increase taxes to pay for higher military expenditures is also more limited. This is because the tax base has remained narrower than it should be. By continuing to rely far more on indirect taxes (i.e., taxes on goods and services, including the VAT and import duties) than direct taxes on incomes or property, it becomes more difficult to quickly increase taxes. Worries about how the government might address the need for additional revenues. Another local analyst expressed concerns this week that “The government may bring back a defence levy of around five percent to pay for military expenses, which puts a squeeze on private sector limits to spend for upcoming expansion plans.” In other words, a resumption of the defence levy would also negatively impact the investment climate.

Recognizing the Price of War
While the Sri Lankan economy has generally managed to maintain a moderate rate of economic growth during the last two decades, despite an active conflict during much of this time, this should not lead one to conclude that there are no economic costs from a war. Despite the growth that was achieved, it is almost certainly the case that the economy would have grown substantially faster if there had been peace. Without the long conflict, incomes throughout the country would have been much higher and poverty much less pervasive. In making the critical decisions about war and peace, it is important to recognize the full price of the decisions being taken.