Report No. 11862^(CE Sri Lanka: Country Economic Update FY93 Public Sector Rati'onalization for Private Sector Development and Povert Alleviation June 2, 1993 Count.ry Dquartment III South AsiaRegion FOR OFFICIAL USE ONLY C~~~ TypeAT FY3 Authr g6AR8s:D0091 Dept. :SA3CI Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
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Sri Lanka: Country Economic Update FY93...Maatu value added expanded at an avage pace of 7% p.s in 1990-92, higher than the growth d in the 1980s. Agricu s per however, stagnated,
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Report No. 11862^(CE
Sri Lanka: Country Economic Update FY93Public Sector Rati'onalization for Private SectorDevelopment and Povert AlleviationJune 2, 1993
ADB Asian Deveopment BankBOI Board of InvestmentCCPI Colombo Consumes' Price IndexCPC C¢ylon Petroleum CorporationCEB Ceylon Ectricty BoardCWE Cooperative Wholesale EstablishmentEDB Expor Deveomet BoardERC Economic Reftucuring CreditFDI Foreign Direct InestmentFLAS Foreign Invetment Advioy SeicesFSP Poor Relief Food Stamp ProgramOATT General Agrmnt on Taiffs and TradeOCEC rater Colombo Economi CommissionGDP Ons Domestic ProductGNP Gro Natonal Prodtut1DA Internatonal Development AssociationIFC nal Fae CorporationJSP Jansaviya ProgramMDMP Mid-Day Meal ProgramMFA Multfiber ArrangementNI= Non-Tariff BarriersPFDC Private Finance Development CreditPIP Public Investment ProgramPMEAC Public Manufacturing Enterprise Adjustment CreditPRDA Prvincial Road Development AuthorityREER Real Effective Exchange RateSLR Sri Fanka RaiwaysTIN Tax Idenfication NumberVAT Value-added tax
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SRI IANKA,PUBlUC SECTOR RATIONAULZATION FOR PRIVATE
SECTOR DEVEWPMENT AND POVERTY AUEVIUAON
CONTENTS
ErEamE SUM AY .................................... i - vii
1. RECENT DEVELOPMENTS IN STABIIZ7ATION ANDSTRUCTURAL REFORM.. 1
L BACKGROUNID .
IL EONOMIC GRO SVINGS AND DINOSANdIENT TM..............2A, SectoralGrowth ............................ .. 2BR InvstnentandSavings ............. ...... ...... .4
I1L SrABILIZATION AND ENHANCED ADJUSTMENT EFFORTS ...... ... 4A. FisocalDeveopments .......................................... 4B. Pubic Entrprise Reform ........................................ 5C. Resowue MobIziMion and Tax Ref&io ... ........................ .6D. Deficit Financin, Money and Caodt .............................. .7E Pricsand Wages ..................... ........... 8F. Curet Aount, Baance of Payments and External
IV. TRADE REFORM AND THE DEREGULATION OF ECONOMICACTDVrYf ........................... 8
A. Rcifonnofthe bnportRegime .................................. 19B. C ostonuEflcbamy .................V ......... ....... 19C Rclplatoy Refrms ....................... 1
7W tepwp m I tl y Sadi AEmmsd Ozuali KaIntoofIu, Hap Dim, A. 4 K=meV^ Pef Aft .i MeudmhI ft1.P.O.b pioIie valuti ~amie =*um taa
CXONTlETS (coat) Page N&
3. POVERTY IN SRI LANKA .......................................... 21
L THE NATURBE OF POVERTY IN SRI LANKA .... .............. . 21A. bmP Pov".... * ........... o.... *.... *. o.. 21. Other Indiators of Human Welfie . ........................... 24C Sunming Up ......... 25
IL GROWTHL HUMAN RESOURCE DEVELOPM[ENT ANDSAFT-NnET PROGRBAMIS ............................. 25
A. rowth Perforna ........ 25B, Eeqging Iwsues in Education and Health .......................... 28
STATISTICAL ANNEX OF TABLES (Table 1.1 to 1.38) ....... .. 41
MAP
LLST OF T TABLES
CHAPTER 1
Table 1-1: KyEy on.onmic ldiatc s .......................................... 3Table 1-2: Incase it Cosuers' Price Index .................................. . 9Table 1-3: Exerna Sector Prformance . .. ................................... 10Table 14: InteM aond Wage Comparisons & REER ............................ 11
CHAPTfR 3
T1l 3.1: StUdie of Absolute Poverty ...................................... . 22Table 3-2: Sri Lanka and Other Lower and MiddleIncome Counties-A Comparo
1. Endowed with a richly varied natural resource base and well-developed humnresources, Sri Lana has good develpment potential. Reazing this full potenal has beenconstainedby etni and poli violne rectly dramatized by the unfortunae as_nt_of Presdent Premadasa. On the ecnomi front, the stop-go nawe of poliy refms has beenanother cidt obstacle to aciev rapid and sutaind economic growth. This report reviw therooet proge with stabiization and struc reform polcies, examines the trends in economicperforne and pover reducon, and identifies an agenda for frther refoms.
2. The repon conclud that, with the resumptionf adjustment effort snc 1989,some encouraging progress has been made m a number of plihcy area which has helped reducemacoeconomic imbalancs and raised economic growth. Neverthless, there is a substantialunfeinshed policy agenda. On the political side, the astion of the Preddt has hegtneduncertain Futue ecomic prospect will criticay depend upon the new leadershipls apacityto sustain peace efforts and to push head sntly with te implementatio of the neededeowomic refom With favable deelpmets in these two areas, it shoud be possible for SriLank to acelerte its a growth rate to 6% pa. ove the mediumterm. Aceving this gowthpath will be critical for enurig sustaned prgre ss in poverty reuctia and furthe humadevelopmenL.
IL ECON-OMIC DEVE:M
3. Sni Ianas economy has erinced a rebound m gowth since late 1989, spwrrdby renewed stabhiation and adjustment effors The toIrm effrt focssed on rOducingmacoeconomic imbalances ad improving the incentves for private sector ough privatzatlo,rade and eteral payments reforms The rebound was broad4bsed, wistrowg gwwth in
industy wd sevie (in the private sector), and a rapid expanion of domestic and foreign privateinvestment Real GDP rose by an aver-ge of 5% p.s during 1990-92, as compared with 2.7% in1987-8, the budget defici was reduced to 7.4% of GDP frm 11.2% in 1989; aveae inflindecelerated to 11.4% from 20% in 1990, the curart amount deficit declined to 5.5% of GDPfrom 7.1% in 1989, the overall balance of pyments recorded surpses in 1990-92 and oficialreserves rose to 33 months of imports by the end of 1992.
4. The reforms, resulting in more market-oriented incentives, produced a significantprivate sector response Prate investment increased from 88% of GDP in 1988 to 16.7% in1992. Much of this intment went to manucturn, which in tum providd te man impetusto gmowth. Maatu value added expanded at an avage pace of 7% p.s in 1990-92, higherthan the growth d in the 1980s. Agricu s per however, stagnated,growiog by oDy 0.5% pa over the past fie yem, maiy refectg iappropriate domesticpolcies Although grwth prmance in the s secor ws ondable with the rcoveyin toursm-53% in 1990-9Z, higher than the 2.7% in 1987-this peroace is still belowpotential becaue of inefficiencies in the large public service entities.
S. Despite the reduction In m economic baacs the quality of the fiadjustmnt and dippages in Impl n metaty piHcy targets are of corn TMe budgetdeit was reduced largely thr smaller tansfer to stae ntepises and rstruturing ofpublic capital spending. But mounting presures on current expeditures a preented astrone, sustainable fical adjustmet In additim to lwer capital spending, enditures onmaintenance fell to at the escalation in spending an defense, civ sevie sabaies anddebt servie ablgatin Defiense spending rose fm 31% of GDP in 1989 to 42% in 1952,illustrating the risig fiscal burden of the civil war. Wages and salres which akeady acount fora big share of public ependitures (4.9 of GDP in 1992) are ecpected to inrae furt in1993 bec_s of acros-the-board wage increases for civil sernt Debt service, the rges.component in curet ependitures, accounted for 6% of GDP in 1992. On the monetary polcddp slippages In npolc tr resulted in a rapid epanson of mone supply in1990-92. Hower, moneta control measures have been more reetly (April1993). On the strctural font, whie good progess was made in the prvtization of smal andmedium entpries and reform of the trade and extea payments pstem pgre has beenweak in reoming the banking sector, the large publc entises in the services sector andagrltural sector policies.
mTL RHEflFGEN12l
6. Notithstanding the farabl overall ecomic perfirmance in the past threeYeas, Sri Lanka fces major challenges, not least the continuing cvil war whi dearly is exactinga high cost Yet, despite the countrys troubled politcal suation, the private sector has shown aremarkable permanceM The rezation of the Sn Lankas considerable dcpmnt potentidwill, howe, requre a consitent teform effort over the medium-trm. The polc reformprogram launched in 1989 needs not only to be continued but also intensified, in pel withequa vigorous efforts to restre peace.
7. As spdled out in its 1992 Fifth Policy Framework Paper (PFP), the mainobjecti of the Govenmet's reform agenda are accelerated gmoth of output and emplomt,and povety alleviatio As in the past, the focus of the refrm womd need to be: (i) therestr ing of the public sector, pulalyacceleat privatl n and iasing theefficienc of remining public entpise and public (ii) impoving the ta and tadergmes to reduce distortons in pnvate sector eentives; (iu) deregulation of private secto entry,exit and competition; and (iv) strgting of socid servies, pa y health and edtionand pv t of the covge and effiienc of safety-net programs The poposed reformsneed to take place within a macroeonomic fameNwork that further reduces interna and extenlImbdaln
A. Pblic Sw R
& Reform of the public sector shoud tak a two-pronged appmach: (i) publicenterprise reform and prvatat; and (iI) imprved effiiec and rato of publicexpenditures consistent with development objectveL With respect to i e r in thenext two yeas the Govaenen needs to: (i) acimte p*atiton; (i) impose hard budptaryconstants on those public enterprises not to be privatied immediately and hpv monitwoing;(iii) inreaws the autonoy and Imprve the regulatory eionment of the utili and transpcrt
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sectors to facilitate private sector entqr, and (iv) improve the efficiency and profitabfity of state-owned banks, and laying the groundwork for their prIvatizatoDL
9. Whike the privatization program is wel advanced for the smal and mediummanufcturing enterpries, progess in privatn the laer enterpries, particarly in the serioessetr, has proven more dificult. As a first step, the Government should proceed quickly withthe privatization of enterprises where broad agrement appears to exist-CWE (the state-ownedtrading company), the remaining sugar and cement companies, and the remahinng 50% of thetransport-related assets of the Central Transport Board. In the tea sector, initial steps to involvethe private sector (as management contractors) need to be quickly expanded to transferinvestment decisions and risk to private companies. Two other priority issues are the privatizationof the Air Lanka and the two state commercial banks. At the same time that an accelerateddhvestiture program is being implemented, it is important to impose a hard budget constaint forenterprises that are not to be privatized immediately or are likely to remain in the public sectorfor an extended period. Of special concem is the need to address the financial difficles of theCentral Electricity Board (CEB) and the Sri Lanka Railays (SLR); where delays in tariffadjustment are resulting in mounting losses. The 30% increase in CEB's average tariff recentlyannounced is an important first step to make up for these delays In genera, the Governmentneeds to reinforce tne autonomy of public enterprises in decision-making, prepare action plans forthe rationalization and/or divestiture of the public utilities and transport companies, and developreglatory reforms to promote competition and avoid monopoly practices.
10. As to the gublic expenditure reform the main priorities are to: (i) improve theeffiienc of the public investment program (PIP), both on- and off-budget; (ii) containexpenditures for ci service wages and salaries; and (iii) strengtben povety alleviation progrms
rough better targeting. The Bank is curnatly undertaking a review of public expendPreliminay analysis suggests that a number of large projects with doubtful economic benefits havebeen included in the PIP. Tbese require thorough review ed scrutiny. On the other hand,expenditures for infrstructure rehabflitation and operations and maintenance (O & M) for roads,water supply, irrigation and health need to be raised. Along with higher financial resources, thepaning and execution of maintenance also needs improvement. Regarding the containment ofthe civil sevice wage bill, a full solution to the problem calls for a comprehensive reform ofpublic administration over the medium-term. In the short-term, a check on fiurther incaes inthe wages and pensin benefits and a recruitment freeze on lower ranking civil servants,including teachers and health workers, would help contain the civl service wage bill. Finally, thesafty-net progams face targeting and efficieny problems. A carefil reassessment of theseprograms would not only help ensure that the truly poor benefit from the progams, but cnuldalso comnserve finanal resources (see also par. 18).
B. Reorm of the Tax Regiem
11. Although Sr Lankas tax effort (19% of GDP) compares favorably with otherdeveloping countries, serious inefficiencies resulting from the tax stucture remain. In 1990-92,the Government moved to reduce the distorting effects of taxaton on economic activity byimproving the efficiency, flexibility and simplicity of the tax system while safeguarding the overalrevenue effort. The potive impact of this reform has been reduced by the proliferation of taxholidays and administrative inefficiencies. The main focus of further tax reforms needs to be:(i) improving indirect taxation by introducing a VAT and rationalization of the excise duty regime;
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(U) reform of corporate and personal income taes; and (ii) rationalization of tax incentes. Tsxand trade reforms wil need to be implemented in line with the stabi n ptogram, and theoverall tax and trade reform pakae woud ned to be desiped In a manner so as to ensrrevenue neutrality.
C Trade Rehm and the Dergationof Economic Actvity
12. Despite recent reforms, Sri Lanka is still highly protected and regulated, especiallyin agriculture. The Gooverments objective in trade reform should continue to be to reduce thelevel and dispesion of protection and to reduce and eventually eliminte the anti-pt bias.Tariffs have been reduced and should now be fur ratonaized through the removal of specifiduties and special import arrangements and complemented by improvements in customsadmistration. There should be a three-band rate with a maxmum tariff of 35%, and Importcertification should be discontinued. Regarding non-tariff barriers (NTBs), some 200 items stillrequire import licenses, including most agricultunl products lAeralhation of these NTBs shoudbe pursued with increased vigor and speed.
13. The Bank and the IMF have supported a Goverment program aimed at revingcustoms policies, simplifying procedures, stgthening organizon and controls, andcomputerizIng operation. Proges in these areas should continue. To balance revenue
generation and trade fciltation, the Government should (i) move ahead with the contract forthe services of a preshIpment inspection company for a period of three years; and (ii) strngththe customs reform program.
14. Over the medium-term, reform of the legal framework regulating the formation ofcompaies and baniruptcy would facilitate the further development of the pnvate sector.Necessary measures include: institutional improvements in the Department of the Registrar ofCompanies and in the commercial court; facilitation of exit through imprved procedures fordealing with the assets of insolvent ur defunct companies; and improved provisons governingasset restuctuing and rehaiitaion of busineses faced with temporwy d;fficulties. Reform inthis area call for a systematic review of the various underling laws and regldations. Considerabletechnical assistance may be necesay.
D. Poverty Alfiviaton
15. Sri Lanka has established an excement rcord in social development, as evidencedby indicators that compare faoably with much higher income-level economies, especially in termsof life expectq, infant mortality, school enroflment and adult literacy. However, resource andpoliy constraints threaten to undermine sme of these achievements. At the same time,relatively low income growth, especily the recent stagnation of agriculture, raise concoe aboutthe sustainability of the poverty alleviation efforts. Clearly, the ability to accelate and sustai ahigher growth rate overall, and a strong growth in agriculture, will be the key determit offuture progress in reducing poverty. This needs to be complemented with efforts to improve theefficiency of spending on education, health and the safety-net programs.
16. In the area of ug. five issues need to be addressed: (i) he 7% shae ofrecurrent education expenditure consumed by salaries in 1992 left few resources for quality-enhancing expenditures, such as for instructional materials and repairs and maintenance.
(11) lhere s a wide dsrepancy in the resoure allocation per student between small and largeschool (I) bere are aso wide d in the alloction of education resources mprovinc, with the pooer ones getting short shift. (hv) Te sharp increase in the number ofteachers ha led to a studentteaher ratio that is vety low by international standards. (v) Thehigh rate of gowth on spending on unierty education in real terms, combied with the poliy ofno cost recovery, could crowd out higher prioty expnditures on geal educatiowL
17. The key issues in the hbo setr derive largel from the decline frtility andrlted demographi change. As the number oL people 60 and over more than doubles, therwill be an inrae in the burden of diseases with high treatment costs, such as cancer adcardocula dase. These changes, togetr with the strong gwth of private health semicesin recent yes (including widespread pivate pracdoe by publc sector doctors), call for a thoroughpolicy review of the sector, with attention to a number of issues. (i) A regulator and supervioyframework is ned to govern the eatly expanded network of private services (ia) Theincidence of morbidity from several preventable diseases is rising. (iin) Quality differentialsresulting in ovrcrwi at higher level facilities and provincial hospitals and underutflization ofsmaller facilities needs to be addressed by more adequate funding for the latter. (iv) Animbalance may have developed between spending on expanding failities and that on operatiaosand maintn enditures for maintenance ih 1990-92 were only about one-tbird what wsrequired.
I8. The Goverment has traditionaly offered an army of safq-n thattransfer income to certain groups. The most important are the following (i) The Poor ReliefFood Stamp Program (FSP) provides monthly food coupons. It suffers from poor targeting andhence covems many ineligible beneficiaries while Acluding some bona fide ones. Te value of thebenfits per household has fallen dramaticaly, and it is unclar whether the program is achievingits objctiv To reduce costs and impmre progressivity, the JSP targeting methods could beusd to prn the rolls of the FSP. At the same time, the amount of FSP payments perhousehold could be rased (u) Te Janamp Program (JSP) prvxes poor households withfixd monthly cash gants for two years and smaler payments for an i ithereafter.These payments are itended to enable recipients eventually to ext povert. AltWough rcvetchanges bhe greatly imprv targeting, the payments after the end of the two yeas appeareXcessive. More important, there is no real evidence this program enables many to exit poverty.The open-ended monthly payment after two years could be replaced by the FSP with improvedtargeting methods. If cuts need to be made in the safety-net programs, they should mainly comefrom the JSP program (il) The Mid-Day Meal Program (MDMP) is a universal non-targetedprogrm for all children attending primay and secondawy schooL It is aimed at improvingnutrion and increasing attendance and alertness. It may be argued that the distibution ofbenefits is regressive and that the program may be yielding few social benefits per rupee speat.The MDMP coud be restricted to primary school children, where the institutionl impact may bethe largest, to reduce the cost and improve progressivity.
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1V. MEDIUM-TERM PROSPEC AND EEAL FINANCING REOUIMEO
A. Econoic Prospects and Finandig Needs
19. As indicated in the Government's fifth-year PFP, Sri Lank's medium-termmacreconomic objectives are to achieve and maintain a strong rate of GDP grwth of 6% pa.,reduce the fiscal deficit to below 7% of GDP, reduce the external current account deficit to about5% of GDP and maintain price stabflit, while ensuing that scal and envionmental concerare addresed. As noted, Sri Lanka's medium-term prospects criticaly depend upon developmentsin two fronts: status of the civil war and policy progress. With sustained peace efforts andconsistent progress in implementing policy reforms along the lines discussed in Section MI above,Sri Lanas macroeconomic objectives are achievable.
20. The immediate task ahead is to ensure that policy slippages in the area of fiscaland monetaty policies are rversed. Immediate actions should include reviewing expenditureplans for 1993 and beyond, including containing the recent across the board wage increases, theprposed 15,000 rural infrastructure project scheme, the Air Lanka airplane purchase, and the busasembly scheme. At the same time, the severe financial situation of the CEB needs to be quicklyrelieved by implementing the required tari increases. As noted earlier, the Government movedin April 1993 to strengthen monetary controL Thi policy stance needs to be maintaned to avoida regeneraton of inflationary pressures.
21. Assuming that security wil improw and that the Government will implement itsmacroemonomic stabilization and adjustment program forcefully, our projections show that realgrwth wold increase gradualy to about 6% per year, whle inflation is expected to decline to anannual average of about 6% by 1995. A large part of the increase in GDP would come from themanufacturing and services sectors. Continued strong private investment in export-orientedacivities will support a strong manufacturing supply response (gVowing 8-9% p.a). Greaterprivate investment in servces, coupled with improvements in the efficiency of public utilities, wiboost the growth of value added in the services sector (around 6% p.s). Although the output
pansion in agriculture wfll be relatively modest (2-3% p.s), the improvent in incenties inboth plantations and smalLholder agriculture will support greater private investment and a morebuoyant agriculture supply response than in the past.
22. Total investment wfll increase from about 22.5% in 1990-92 to about 25% ofGDP by 1995, with public investment maintained at 99o of GDP. Public investment wilconcentrate on improving economic infrastructue and providing social seice sevces, mainly inbealth and education. To accommodate the higher investment effirt, gross domestc saving willneed to rise by about 3% of GDP by 1995 largely through the expected increase in public saving.The increase in national saving will reduce the dependency on foreign saving for financing a highlevel of investment. Successful implementation of fiscal discipline is crucial to achieving thesaving target The current balance of the budget is expected to improve from a deficit of -0.6%of GDP in 1992 to a surplus of about 2.5% of GDP by 1995, wbile the overall budget deficit wfllneed to drop by an additional 15-2% of GDP to about 6-65% of GDP. Fscal adjustment has totake plac mostly through a rationalization of current expenditures.
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23. Strengthening of the extemal position will be mainly achieved through a strongerexport performance, leading to reduction in the current account deficit to about 5% of GDP.Manufactures are expcted to be the most dynamic ex;rt sector, but traditional exports willregain an upward trend based on improved agricultural performance Imports wil grow moreslowly than expots but wil incree faster than GDP. Large workers' remittances and bigherreceipts from tourism wil also help improve the external sector position. Sri Lanka's capitalaccount is beginng to undergo structural changes. In particular, the share of private and short-term capital inflows has incrased sharply. This trend should boost the availabiity of exteraresources. These developments together with the expected external support program will yieldmarginal surpluses in the overall balance of payments. Under these circumstances, gross officialreserves will rise to four months of imports by 1995, a trend that will facilitate furtherlberalization in the external sector.
24. Under the adjustment scenario discussed above, Sri Lanka's external financingrequireents will be stable at around US$12 billion p.a throughout the projection period. Thislevel of external finaning requirement is within the range of expected donor commitments andprvate capital flows, and the need for external commercial borrowing seems unlikely. In thelong-term, prospect for increasing the levels of official aid are uncertain, reflecting the scarcity ofofficial lending resourc_s and increasing demands elsewhere (eg., Africa, the FSU, etc.). SriLanka's success in attracting these resources in the future wfll depend increasingly on its efficiencyin managing the aid portfolio.
B. Risks and Uncertutes
25. The illustrative adjustment scenario is subject to several risks. An acceleration inpolitical umest is a major threat Apart from the direct financial cost of the civil war, the kus ofoutput through disruption can be substantial Moreover, the acceleration of political unrest willlkely weaken the Government's ability to formulate and implement the required rforms. Evenwithout an acceleration in the civil unrest, the Government may not be able to consistentlyimplement the required reform program. The past experience of stop-go reforms illustrate thisrisk In the event that the implementation of the reform program falters, Sri Lanka's economicperformance would be considerably weaker than that presented in the adjustment scenario (about3% GDP growth p.a), which would have serious adverse implications for employment andPovt.
26. Externa shocks, especially unexpected changes in the prices of major exports andimports, are another potential source of risks Changes in the Multifber Arrangement (MFA)could affect Sri Lanka's gament exports significantly. To a lesser extent, Sri Lanka is alsovulnerable to variations in international interest rates and exchange rates. In the event that anexternal shock emerges, achievement of high growth will depend heavily on the degree and speedof the Govement's response in terms of compensatory policy reforms. While the adverseconsequences of small, temporary disturbances could be absorbed through reserve damwdown,large external shocks would caU for an appropnate response in terms of a strengthenedmacroeconomic management and structural policy reforms. Over the longer tern, Sri Lankaneeds to minimize these risks through eWort diversification.
1. RECENT DEVELOPMENTS IN STABIIZATIONAND STRUCTURAL REFORM
L BACKGROUND
1.01 Following a period of poor economic performance during 1970-77, theGovernment of Sri Lanka initiated a new economic policy in 1977 that sought to gradualyincrease the role of markets by relaxing the regulations on prvate sector activity. Reformsreduced the restrictions on pricing, investment, and extera trade and payments. The supplyresponse was strong: the average annual rate of GDP growth inrased to 6% dunng 1978-82compared with about 3% in the early 1970s (see Annex Table 1.1). lbe donor communitysupported the liberalization policies with grants and concessional lending for investment programs,particularly for irrigation.
1.02 In 1983, the civil situation deteriorated because of the escalating ethnic andpolitical conflicts, reaching a crisis in 1987-89, that hurt the economy badly. However, theeconomy was also hurt by the faltering nature of the Goverment's adjustment program. Therfm progam of 1977 was not folowed through with further measures to address the remainngstructural constuaints, particlarly the need to restructure the burdensome public sector, whichdominated ag tue, industty and services. Growth of GDP decelerated to only 2.9% p.a. in1987-89. Pronounced macromnomic imbalances emerged as a result of the large and inefficientpublic sector that had been eft intact. The current account deficit was about 10% of GDP in195-87; the fiscal deficit exceeded 15% of GDP in 1988, a reflection of the size of the publicsector. A large savig-imvestment gap reinforced the heavy reliance on foreign borrownng toawommodate public sector spendig. Strucural constraints at the sectoral level inhibited gains ine*ien and gowth in factor productivity.
1.03 In late 1989, renewed stabilization and adjustment efforts emerged. How effectivewas this reform effort? This Chapter looks at the progress in stabilization and structural reformssince 1989 and its impact on economic performance. The main conclusions are:
e The economic rebound resulting from reforms since 1989 has been broad-based,with strong growth in manufacturing and services (in the private sector) and rapide_pnsion of domestic and foreign private investment. Notwithstanding adeterioration in the terms of trade, real GDP grew by an average of 5% during1990-92 (see Table 1.1).
o Consumer price inflation decelerated to 12% in 1991 and 11% in 199Z after risingby more than 20% in 1990.
* The external current account deficit as a percent of GDP was reduced to 5.5% in1992, down from 7.1% in 1989. The overall balance of payments ran surpluses in1990-92 that contrasted with the deficits of the previous five yeas Grow officialreserves rose from 1.5 months of imports in 1989 to 3.3 months by the end of1992, buoyed by higher concessional aid and inflows of private capital.
o Progress on the fiscal front has been mixed. While the budget deficit was reducedfrom 11.2% in 1989 to 7.4% in 199, largely through reduced transfers to stateenterprises and restucturing of public capital spending, mounting pressures on the
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current expenditures prevented a stronger, sustainable fiscal adjustment.
o Some slippages also emerged in the monetary policy implementation during 1991-92. Domestic liquidity expanded rapidly because of growth in private sector credit,unsterilized icre in net foreign assets and a large expansion of credit to theCeylon Electricity Board. However, monetary control measures were strengthenedmore recently (April 1993).
o Good progress has been made in implementing structural reforms in a number ofareas--ecan and payments system, privatization and trade reforms. Paetlcubanoteworthy is the progress made in hberalizing the current account of the BOP,including relaxing the requirement to surrender export earnings in foreignexchange. However, progress has been weak in reforming the banking sector, thelarge public enterprises in the services sector and the agncultural sector incentives.
IL EC:ONOMIC GROWTH SAVINGS AND INVESTMENT
A. Sector Growth
1.04 As noted, GDP growth rebounded in 1989-92, growing by an average of 5% p.a,as compared with 2.7% in 1987-89. The sectoral composition of growth is shown in Annex Table13. The changing composition of Sri IA s GDP reflects progress on the strucural reforms.The liberaliztion and privatization efforts since 1977 have centered on manufactuin& whoserelative share in total output epnded from 14.4% in 1982 to 16.8% in 1989. The broad-basedpriate sector response to the more market-oriented incentives influenced industrial performance.The more recent reforms starting in late 1989 have further boosted the manufacturing sector'sgrowth performance Value added in manufacturing grew by 7.9% on average during 1990-92 ascompared with 6% p.a. in 1982-89. As a result, the manufactring sector's output share grew to185% in 1992.
1.05 In contrast, agriculture's growth performance faltered (0.5% pa. over the past fiveyears), part due to adverse weather conditions in 1991-92 but mainly because of inappropriateagricultural sector policies. The drought in late 1991 and the first half of 1992 hurt rain-fedexport crops, and tea production in 1992 was 18% below the normal five-year average. Thedecline in value-added from plantation crops (some 24% of agricultural value-added) and frompaddy (23% of sectoral value-added), 2.9% p.a. and 2% p.a. on average since 1985, respectively,lie behind this weak performance. Government policies have traditionally been directed atachieving food self-sufficiency. Tbese policies include cropping and land-use restrictions, andexsceive protection of food crops, especially rice, leading to significant efficiency losses. In theplantations subsector, inefficient public corporations are the main factor explaining the subsector'sdecline.
1.06 The service sector accounted for more than half the increase in GDP durming thelast decade. The average growth increased in the early 1990s to 53%, as compared with 43%p.a during 1982-89 and only 2.7% in 1987-89. However, this performance remains modest whencompared with the sectors potentiaL Inefficiencies in the large public corporations, whichdominate trade, transport and utilities, are a major constraint on the performance of the servicessectr.
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Table 1-1: KEY ECONOMIC INDICATORS
1. Natlona-iIncome & ExpenditureGrowth of GCNP (at constant prk#4 (qb) 2.7 2.3 6.2 4.6 4.3GNP Per Capita US $ 375 367 417 460 494InvestmenUGDP FRaio (qb) 22.8 21.7 22.2 22.9 23.7Domestic SavingsGDP Ratio (*) 12.0 122 14.3 127 15.3
3. Pries and Real WagesAnnual Change In Consumer Prce Index (%) 14.0 11.6 21.5 12.2 11.4Annual Chanoe In GNP Deflator (%) 11.5 9.9 20.0 10.5 9.9Minimum Wage Index Wages Boards (1978-100) 107.9 112.0 107.6 109.7 112.0Government Wage Ind (19786100) 125.4 121.9 113.2 113.2 106.0
4. Public FinanceGovt. Revenue as% of GOP 18. 21.4 21.1 20.4 20.3Govt. Current Expenditure as % of GOP 20.8 22.6 22.3 225 21.0Govt. Capital Expenditure as % of GDP 13.7 10.0 8.7 9.6 6.8Budgeto Deficit as % of GDP -15.7 -11.2 -9.9 -11.6 -7.4Domesti Bank Borroulng o % of GOP 4.6 -1.3 0.1 -0.2 -0.5
5. Money Credit (Annu4l Increase)Growth in Broad Money(M)(%) 16.6 11.3 20.5 22.1 17.4Growth In Domestic Credit () 28.8 5.1 14.6 10.2 12.7Growth In Public Sector Borrowing (%) 37.4 5.5 4.2 -3.0 -3.3Growth In Prvate Sector Credi (9) 21.7 4.7 24.3 20.5 19.6
Soc: Cm" Bank of Sd Larn and DepatnW of Cemm and SNUB&$
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L Inestment and Savi&
1.07 ITe private investment response to the stabilization and structural reforms hasbeen significant. Grass fixed prvate investment incresed from 8.8% of GDP in 1988 to 13% in1991 and 16.7% in 1992 (Annex Table 1.4). Foreign direct investment more than doubled in1992, although still accounting for only 5.4% of total investment. Total gross investment rosefrom 21.7% of GDP in 1989 to 22.9% in 1991 and 23.7% in 1992. Ibisrise is attrbutableexclusively to pdvate investment: the private sector investment index rose by 43 base pointsbetween 1987 and 1991, whee the public index declined by about 27 base points during thesame pernod Reliance on the stock market for investment financing rose significantly with theacceleration in privatizaton and pent-up demand for affordable finance.
1.08 Despite recent reform efforts, public spending continues to crowd out privateactivity. In 1992, public domestic saving remamed negative at -0.6% of GDP, a slightimprovement over the -2.0% of GDP in 1991. Because of increased remittances and otherpriat foreign traDsfer, private national saving rose from 14.6% of GDP in 1989 to 183% in1992, with financing from faoeign savmng accounting for about 23% of gross domestic investment. Gross domestic saving rose modestly from 12.2% of GDP in 1989 to 12.7% in 1991 but thenieased sigificntly to 153% in 1992, in part becase of the reduced budget deficit.
LIL STABILUTION AND ENHANCED ADJUSTMENT EFFORTS
A. FisaDevebpucuts
1.09 Despite coretive measures since late 1989, fiscal pressures remain significant.Moreover, notwithstandig a substantial declie in the fiscal deficit from 16% of GDP in 1980 toaround 7% in 1992, the upward pressure on current spending in the 199Xs raise some concernabout the long-term sustiability of the fiscal deficit reduction effort.
1.10 Exped sas a shae of GDP decined from a peak of 43% in 1980 to 28% in1992. Te evel and composition of publc expenditures are critical for stablization andadjustment. Sine 1990, the share of curent expenditures has risen she -ly, while the share ofcapital expenditures has fialen to accommodate escalating defense spending, new welfare schemesand greater debt servce obligation. Wages and salaries, at 4.9% of GDP in 199, are ected:to increase further in 1993 because of a proposed across-the-board 30% percent wage "a rease forcH servants, which will apply regrdlss of productivity gains or performance (equivalent to aneffecve 169b percent effective increase in the wage bill over the 1992 level). This increse isdouble that contemplated in the Goverment's fifth-year PFP. Expendiures for defense rose to4.2% of GDP in 1992, up from 3.1% of GDP in 1989. Debt service, now the largest componentin the budget cment e ture, accounted for 6% of GDP in 1992, as the public debt reached96% of GDP. Much of this refect the sevicing needs for domestic debt; because ofcnesional terms for foreign lending, the foreig debt serice is only about 1% of GDP.
1.11 Transfers to households reached 5% of GDP, as new welfire schemes came onstream and pension benefits from the non-contbutoy civil service pension scheme increased(2.4% of GDP in 1991). One positive feature, however, was the reduction in budgetary transfersto public enterpries. Current transis to public enterprises declined to 0.4% of GDP in 1992,
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down from 1.1% in 1989. Furthermore, the Government has used reductions in capital transfersto public entitles to rationalize public expenditure; nevertheless, these capital transfers stillaccounted for about 3% of GDP in 1992.
1.12 On the public investment side, overall spending was cut to bring in the fiscaladjustment. Much of the cutbacls were concentrated on large str projects, especiallyin irration Wbile the Govenment has rightly emphasized attention to basic infrastrcture in itscurrent public imvestment program, inclusion of a number of large projects with doubtfuleconomic benefits and inadequate attention to and 0 & M remain a major concer
1.13 As to reform of public administration, the Government has not yet met itsobjectves with respect to restcturing the civ service. There is still overstafflng the number ofcivil servants in both the Central Govrment and Prvincial Councils appear to have inceasedsubstantially since 1988, and hiring is still underway in education. Generous severance packageshave doubled the civil service pension bM from around Rs 4 bilion to Rs 8 billon per year.Because the benefits of the pension fund are not linked to a retu on contributions, theGovernment has to cover any obligation out of current resources.
FL Publlc Enterprise Reform
1.14 The marked difference between private (largely manufactring) and public sector(plantations, sevices) performance has improved the political climate for privatization, whichaccelerated coniderably in 1992. Direct budgetary transfes to public enterpris fell from about1% of GDP in 1989 to 0.4% of GDP in 1992. Howeer, public enterprises continue to burdenthe ficial system, and credit to public enterprises, extended by the two state-owned commercialbank alone, inceased by Rs 1.3 bIlion in 1992. This remains an important source ofmacroeoxnomic instability.
1.15 The Governmt launched its privatiation efforts in 1990, when the insttutionalcapacity for diesthe was streoened somewhat. Greater poltical acceptability and regulatoryreforms encouragg paricipation and transfer of ownership to foreigners boosted theprivatzaton program in 1992. A number of policy measures were also introduced to facilitate
ivatition M The tax on the transfer of equity to forignr was eliminated and the 40% limit onforp ownesip was relaxed. Also, in July 1992, the Govenment shifted management of 449public estates to 22 private management companies on a profit-sharing basis. Ihe companies tooka number of small but cria steps to improve m nt. However, because the Governmentgave the companies only five-year contacts, they have been reluctant to make new inmestmentdeciions Mhe Govemment and the private management companies are discussing the convesionOf the contracls to 30-50 year lease-type arrangements, with the private sector assuming the risksHowever, Govenmuent's unilateral decision in late 1992 to raise plantation workers wages by 30%has weakened the fincial viability of the companies.
1.16 With support from the Asian Development Bank, in 1992 the Governmentinitiated the priatization of the sugar industry. Realizaon of the benefits has been hampered bythe limited number of importers operating under restrictive import aangements and high specificimport lvie. A proposed US$500 per ton minimum guaranteed price for private sectorprde could also limit efficiency if implemented.
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1.17 With supot from the Itr al Development Association's (IDA) 1990 PublicManufacturing Enterpre Adjustment Cdit (MEAC), the Goveament prvatized 40% of theshares of mining and minera publc entiti Faced with limited gais from the 40%privatatoi, n 1992 the Government sold up to 90% of the sck in ming companies tocorporate ivsto and distrbuted the remaining 10% to enterprise worker
1.18 he rcet cowneion of the Sri Lanka Telecommunicaton Department to apubic corporaton, with more autonomous maagemet, and the opening of tlecommunicationservice except for basic telephone seve, to the prvate sctor, have led to better qult, andexpandd services. Transfer of tecdology advances and gains in efficiency would hae been moreproounced had pivate secor prtcipation been edended to basic telephone seric
1.19 Not all the reform efforts have been successful Sodal and political consideratioshave severely constrained the autonomy of the management of almost al public utilities andtraport entities. In particular, the financial situatio of the CEB and SLR is aannin A long-awaited incree in CE's taf has been postponed at the same time that acceleration of therunal eletrification program is placing nabldemands on CEWs limited financialresources. he recent decion to adjust CEB's tarff by 30% is an important first step to improveCs finances, but further increses are still needed. Similarly, badly needed incras inrailroad fares have been stalled, a delay that is also jeoparding the financal viability of SLR.
1.20 Progress on reform of the financial sector has been halting In the comma calbanking sector, eforts so far have fosed on amendig the Bank's Act, recapitiing the twostate-owned cmmerial banks and transferring bad and doubt debts to independent collaectionagncies However, the two state-owned banks, which control more than 50% of commercibank deposits, continue to have limited autonomy in lending decions, despite recent measestaken in this regard, partcularly when they consider public enterprises. As a result, seriousfinancial sector inefficiency and prvate sector crowdig out persists.
121 Six years after the insurance busines was opened to the prate sector, the twostateowned insurance institutions still controlled about 85% of the insuce market In early1993, the Gonment convered the two corporations into companies and is taking steps, prior tointended prnvatization, to regulate the sector properly. The Govenment also continues toeercise control over the Nationa Saving Bank, the Employees' Provident Fund and thedevelopment financial institutions even though it has recently privatized the NationalDeveopment BanL
C. Resource M a and Ta Rdfo
1.22 The tax revenue effort in recent years has been at about 18-19% of GDP, whiletotal revnues are in the 20-21% of GDP. While this effirt compares favorably with theperlfomance in counties at similar income kv, the tax struure suffe from sinificanteconomic inefficiencies. Tax refim has been a part of the policy rerm agenda since 1990. Ithas three basc themes: a wideing of the direct and idirec tax base; reduction of the marginalrates for income taxes; simplfation of the indirect taUes; and review of the administratiestucture for improved effcien and greater tax complanc A major problem has been theproliferation of tax hoidas, a trend that has crtical implcations for effiienc andmacroeconomic stability. The inability to reform the tax hoidays and tax concesons is hurting
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effot to expand the tax base, cua tax evasion and improve the efficiency of the system
123 Since 1990, the Govrnment has made excelent prosin comput ginfomation for the brgest taxpayers. In 1993, it wil computeriz the indirec and direct taxrturns of 2,000 corpora tape accounting for 80% of retun Stil compliance is weak andefts to broaden the tax base and improve enforcement need strengthenin Refm to shiftthe iciece of taxation fm production to consumption led to the elimination of export txe in1993. Thes revenues fell from 5.6% of GDP in 1980 to 0.2% in 1992Q reveu frminterntiol trade ta decined from about 10% of GDP in 1980 to 5% in 1992, lagely becaeof the drop in export ta8 (se Annex Table 1.16). Import tax revenues rose from about 3% ofGDP in the early 198Qs to 5% in 1992, as tarff replaced most non-tariff barriems
1.24 Nevertheless, reliance on indit taxe re;i substantiaL In 199Q, direct taxesgenerated less than 17% of total revenues, despite the marked expanion in prvate sector activity.Income taxes generated ess than 3% of GDP in 1992 and corporate ime taxes only 2%. Theshare of indirect taxe reached 9% of GDP.
1.25 During 1990-9Q, the Govrnent moved to reduce the distortng effects oftaxtion on economic activity by improving the effidency, flexibility and simplicity of the taxsystem while safeguarding the overall revenue effort. The maximum corporate income tax ratewas reduced from 50% to 4S% in 1992 and 40% in 1993. he Government modified thedepredatio schedules in 1993 to reflect the economic life of investment lTe tax-free tsholdfor persona taxes was raised, and the maximum marginal tax rate was reduced to 35%.
1.26 In a move to establish a value-added tax (VAT), the Govenment took steps tosimplify the rate stuctre of the turnover tax, reduce the cascading ekment and broaden itscoverage. The number of rate bands in the tunover tax went from 10 to 3, input credits for rawmatenals and capital goods wer made available, an( the number of goods subject to zero rateswas reduced. Moreover, the tuover tax on finanal ittutions was lowered, while the capitalgains tax and stamp duties on share tansactio were removed to encourage financialintermeiation and development of the capital markets Stamp duties on letters of credits werereduced, a step that lessened the exchange distortion Purely on revenue grounds, the coverageof eiske taxes ws expanded to a large number of consumer items
1.27 Impwving the admInitrtion of customs has proven dificul The Goementhas taen inita steps to cnt for a three-year period the servies of a preshipment ikspectionagency to expedite import procedures and reduce lakage from the export promotion schemes. AVAT is tentaively planned for April 1994.
D. Deficit Fluanclug Monw sad Cedt
1.28 The budget deficit was financed through foreign grants and loans, domestic non-bank borowing and domestic bank borrowing. While freign grants d concessional foreignborrowing have virually no or vey low interest cost, domestic borrowing, paricularly from themarket is expeive because of high domestic iterest rates During the last three yeas, the shareof foreign sources in deficit financing rose somewhat to about 6% of GDP during 1990-92, withforeign grants at about 2% of GDP and foreign loans at about 4%. Project loans hae becomethe major conbutor to budget deficit financig, while net non-project loans have decined
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bcause of net repayments in recent years.
1.29 Domestic bowing dedlined to 3.6% of GDP in 199Z, from about 6% in thesecond half of the 1980L Furthermore, eept for 1990, net borfowing fhm the baking gstemhas been negative since 1988. Domestic n-market bomwing declined in favor boowig atmarket rates Tbese developments are encouraging and indicate a move towards a more prudentiscal policy and reduction in tresuy bill holdings by the Central Ban.
130 Monetary expasion has been high during 1990292 period because of high pdvatesector demand for credit and the limited capacity of open market operations to neutalie theexcess liquidity created by net foreign assets. Credit to the private sector decelerated onlymoderately, from 24.3% in 1990 to 20.5% in 1991 and 19.6% in 1992 (Annex Table 1.18).Private demand for credit partly reflects the greater credit requirements for financig theprivatization program, but mostly the need to fice the 200rment factory progam Althoughthe expansion of credit to the public sect, espedaly the Govenment, has deceleratedsubstantally since 1988 and in fact turned negative in 1991-92, the adjustment has been less thananticipated.
131 In the last three years, the Governmet has imposed credit ceings on mjorpublic entities. There was a noticeable reduction in credit to public corporations in 1991, as oansto the plantations sector wer converted into Government equity. Nevertheess, a number oflaWe public entities continue to exit excessive reliance on credit, over and above worigcapital needs, and credit to public enterprises increased, albeit by onl 5%, in 1992. For exampl,during 1992 credit to CEB and J _ increased by Rs 2 billion and Rs 08 bilon,respectvl
132 One positive development in monety polcy management has been that theGovernment has shifted from non-market instruments or direct controls for monetarymanagement to indirect measures, mainly open market operations In 1991, the Governmentinitiated steps to curtail the refinance facilities and raise the refieance interest rates towards themarket rates. In 1992, it also extended the coverage of the statutory reserve requirements toinclude foreign currec deposits with commercial banks.
E Primces and Wages
1.33 Inflation, as measured by the Colombo Consumers' Price Index (CCPI),decelerated to an average of 12.2% in 1991 and 11.4% in 1992. At the end of 1992, hower,inflation accelerated as a result of slippages in monetary policy as wel as cost-push fctors durngthe second half of 1992. The Greater Colombo Price Index (GCP1) with 1989 weights and alarger product coverage displayed similar trends.
1.34 Expectations of inflation were strng in late 1992, fueled by concems overmoneta grwth. On the cost side, the depreciation of the rupee and incres in the defenselevy (from 1% to 3%) contributed to inflation. Most important, however, was the announementof the wage increase for the public sector. Thbs decision, together with deteioration in SriLankas overal competitive position, necessitated a more active echange rate policy.
Souwre: CenCad Bank of Sri Lanka and Depamen of Censs and Saistcs
135 MInimum real wages in the wage boards have kept up wMth inflation, while realwages in the state sector have declined. Significant wage incres were recorded in the infformalsector. As noted, the Government bas proposed a major wage increase for the formal sector.Mme wage increases dereed for unskilled textile and plantation labor wi further flatten the waestructue, another obsace to productivity gains
F. Cuemt Amomit, lBalnce of Payments and Exteal Reee Poson
1.36 The curent account deficit increased from 5.5% of GDP in 1990 to 7.6% in 1991as the grwth in ats slowed and the incaes in imports, including secuty-related ones, werehigher than epected. In 1992, extenal sector accomplishments fell back in line with the targetsof the PFP, and in fact the reduction in current account deficit to 55% of GDP was well belowthe target of 6.4%. Imports rose mainly because of increased rice and wheat import and importsof intermediates for the gment subsector. Record grwth in industial exports offset thedrought-related decline in traditional exports, while service receipts InTeasd substatially as aresult of significant mprovements in the tourist industiy. Private traner receipts rose by about30%. An increase i service account outflows in 1992, partly explained by the relaxation ofcontrols on service payments, was offset by corresponding increases in inflows.
137 The overall balance of payments has run a surplus shie 1990, a reflection of theincreased concsionay lending and private capital inows. Gross infows of ocesnary loanand grants averaged 5.4% of GDP in 1992, while extn debt service rates decined from 28.6%in 1988 to 15.7% in 1992. Consequently, the gs official reserve position was strengned from1.5 months of imports in 1989 to 3.3 months of imports at the end of 1992.
1.38 The composition of exports has shifted from agriculture toward manufacturi andprocessing. In 1992, gross industrial exports were 69% of total exports, venus 15% in 1977, whilethe share of agculual exports decined from 79% in 1977 to 24% in 1992. Ihe value of tea
xports fe from 44% of exports in the late 1970s to 20% in the early 1990X Gross grment
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Table 1I3: EXTERNAL SECrOR PERFORMANCE
1988 1989 1990 1991 1992
Trade Acount Dect (% of GDP) 109 9.6 8.8 11.1 IQOCurrent Account Delicit (% of GDP) 85 7.1 5.5 7.6 5.5Loas & Grants (% of GDP) 86 7.1 7.2 9.1 5.4Debt Servioe Ratio 28.6 242 17.8 1&1 15.7Ovemll Deflcit/
Surplus US$ Mn. .86 -86 181 209 183Import Capacity of GwoOfficial Reserve (No. of Months) 1.5 1.5 1.9 2.7 33
Soww CnW Bank of Sh Lanka.
exports, which accounted about 2% of total expots in 1977, represented 48% of t grosseports n 1992. Although agricultural xports share declined to about one-third of the totalexport earnings, their share in net export earnings has been sbsatiallyr higher because of thelow requrm sfor imported inputs
139 Nootwtsnding the broad sectora shifts, eos have remained narrowly basedan tea, rubber and grments, and there has been little vicaon within theme categoriesBuk tea accounted for 65% of total tea erts in 1992, and the share of high value-addedgaments in total gament exports has been malL Ibe export product dn indexndicate only margioad improements in the last 15 years, and the export market divrficationindex reflect ireased export market over time.
lAO Sri Lnkaws external competitive reflects is inexpens, quality labor, chagiutural lad and potential touist sites. Its labor costs influence the competi of thepredoinantly labor-ienive industrial export sector in part. Sice 1989, the Govermenthas followed e_hange policies aimed at _Saudin the country's cmpartive advantage. In thesecond half of 1992, eochange rate mmements in neighboring countries and Europe (particularlythe devaluation of the pound sterling) and higher domestic iflation raied quesions about theadequaq of the exchange rate policy for the countrys competiivene and export driv. Ihedepreciation of the rupee, thefore, accelrated after mid-December 1992, a trend that improvedexter competit somewha e rupoe depqiated aginst the dolar by 6% in 1991, afurther 8% in 1992, and 32% in the fist quarter of 1993. The reale et ehange rate,howver, appiated steadily from 1989 until end 1991, but the trend was reversd in 1992 andthe real effecive excange rate is nclose to the 1989 level (Annex Table 1.1). On average,howev, Sri Lan still compares fvorably wth most cmpetitors in the region (soe Table 1-4).
1.41 Pardcularly since 1990, Sri Lanka has been offering generous tax incentives topromote exports and encourage foreip direct investment. Tenyear tax holidays starting from thefirst yea of profits appear to have had little efft on the cost of capital and thus on future
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IFIbl 14: INTERNATIONAL WAGE COvIPARISONS ANDREAL EFFECTIVE EXCHANGE RATE (REER)
REER 1991 FACrORY WORKERS(1987 100) (US$ per month)
Sri Lanka 109.2 40.25Pakdstan 71.5 54.14India 633 66.09Bangladesh 106.2 40.22
Source: Wodd Bak Foreign Invesment Advisoiy Sevice, MIGA
imvestment. On the other hand, they have distorted relative prices and adversely affectedefficiency in resource allocation, while hurting macroeconomic stability. Research on experiencefrom other countries cast serious doubt on the eficacy of tax incetves for attacting foreigninvestments. Similarly, the positive impact of the recent policy to move industries into remoteareas with tax incentiv but inadequate itructure is questionable.
1.42 Notable progress has been made in lberalizing the external payments system. In1992, the Govenment liberalized the repatriation of profits and dividends The facility to openforeign currency accounts was extended to all residents, and capital transfers to c"igrants wereraied. In eady 1993, payments for business, tourism and education were fully liberalizedLSimlarly, the export surrender requiements were elimated so that exporters can keep thepoceeds from exports in foreign cuncieLs Sri La also eliminated the limits on foreignexchange for travel, education, medical treatment and penion remittances. Domestic residentscan open foreign curenT acoounts in Sri Laka with no disclosure requirements. Howeve,domestic residents are generally not permitted to hold investments abroad and must have theapproal of the Central Bank to borow in external makets
G. Thude Reforms
1.43 Good progress has been made in reducing and rationalizing nominal protecdon.The 1992 tariff stm was dominated by four rates (10, 20, 35 and 50%). However, a number ofitems were not subject to any duty, others to rates higher ta the 50% maximum, and there wasan import tax of 10% on the duty paid on imports dutiable at 50% or above, with the proceeds tofinance the Export Development Board (EDB). Specific duty rates or refrence prices, whichcover about 1,000 out of the 6,000 tari lines and represented more than 30% of the value ofimports in 1990, were introduced in 1991 ater the maximum rate was lowered. Ihese rates varsigficantly, with ad valorem equivalents axeeding 100% in many cases. Specific rates applicable
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to tho textile subsector wee converted into 100% ad valorei as of May 1, 1993.
1.44 The role of NTBs, howv, remains sigificnt. Some 200 items con torequ import licenses. In some case the rationale is national security, health or evirnmentaprotc Other items, however, are on the list for protectonist reasons Tem majority of theseare agriculal good Progess has ben achieved in eliminating the state import monopoies foragricultural commodities: those for rice and sugar were lifted in the 1960, and import leensesreplaced the CWE import monopolies on major staples in 1992. Ucenses are stil required forrice, sugar, m,lk onions, leatils, wheat and wheat flour, and molasses. Import cses andseasonal quotas for rice and sugar are allocated to the CWE and to a limited number of privateagents. These agents are entrusted with maintaning buffer stocks to avoid short-term shortages,especially in view of uncoertnties aring from the civil war. An import prohibitions s til ineffect on potatoes.
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2. THE ADJUSTMENT AGENDA FOR PRIVATE SECTOR GROWTHANM PUBLIC SECTOR RATIONALIZATION
2.01 Notwithstanding the favorable overall economic performance in the past threeyears, Sri Lanka faces major challenges, not least the continuing civil war which clealy i eactinga high cast Yet, despite the country's troubled political situation, the private sector has shown aremarkable performance. The reaition of Sri Lanka's considerable development potential wil,however, require a consistent reform effort over the medium-tem Te policy reform programlaunched in 1989 needs not only to be continued but also intewifide in parallel with equallyvigorous efforts to restore peace. This chapter reviews the main areas where further reforms areneeded In the coming years in order to achieve and sustain a higher pace of economic growth,which is necessary to reduce poverty.
2.02 The adjustment agenda would need to support reform of: (i) the public sector,particrly public enterprises and improved allocation of public ependitures; (ii) the tax, andtrade regimes to reduce distortions in prvate sector incentives; and (iii) regulation of privatesector entry, eit and competition. A reduced state role in commercia activies, Ibe on ofthe trade regime and economic deregulation would foster prnvate entrepreneurship and greaterefficiency in resource utlization, while rationalizatin of the public sector would release resourcesfor private sector, incrae effciency in resource use and provide resources to improve theprovision of infrastructure and social services. Rationalization of the public sector is critical forthe Government to meet its policy objectives of incresed gowth across regions and activitiesthrough a dynmc private sector, but most important, the proposed reforms would need to takeplace within a macroeconomic finework that substantally reduces internal and ex alimbalance The Govment's fifth-year Policy Framework Paper (PFP) restated its commitmentto sound macroeconomic management
L THE CHALNGE OF EXPORT-LED GROWTH ANDTHE TTA REM PROGRAM
2.03 The chief priority for the Government's adjustment program needs to be therationalization of the public sector, partularly public entrprise reform. Ihe program also needsto strengthen ongoing measures to reform the tax regime and tax incenties and to liberalize tradeand dereulat economic activity. Reform of the publc sector is necesary for meeting privatesector and social equity policy objectives. A smaller and more effiient pubLic sector wouldrelease resources for private sector acvity, lessen inflationary pressures and fcilitate financialintermediation. Further liberalzation of exemal trade and dereguation of the factors ofproduction would result in incremased competition, efficient factor use and reduced relative pricedistortions. All these measures would encourage efficient private sector activity and growth,which in turn will help reduce povert.
2.04 Satisfactory macroeconomic performance is necesary for the success of thestuctural reform agenda Sri Lans medium-term macroeconomic objectv are set out in thefifth-year PFP and are being onitored under the DMFs Enhanced Structral Adjustment Faciity
* -.14-
(ESAF) progam. Agreement on expenditure reductions or revenue measures to be caTried outin 1993 to achieve the PFP and ESAF argets has not vet been completed and an essentialprquisite to proceed with the adjustment agenda. Past effort has yielded some major benefits,reflected in a stronger growt, Investment and export performance. Sustaining and evnacceletating this higher growth performance is a key polcy challenge for Sri Lanka. Without thissustained stronger growth performance, Sri Lans ability to create productive employmentopportunities for its labor force and reduce the incidence of povet will be severelycomprmsed
II. E11LIC SIMOR RATAIONA&IION
2.05 Reform of the publc sector requires a two-tier approach: (i) public enterpriereform and pnvatization; and (ii) improved efficiency and rationalization of public expendituresconsistent with development objectves.
A. Public Enterprise Rerorm1
2.06 As noted in Chapter 1, Sri Lanka has made good progress in the area ofpriaation. lbe Goverment has redefined its privatization objectives and plans to stegthenthe instituions and tcnical skills that are prerequisites for minimizing the risks and acceleratngdiengagement from commercial activities. Recently, it eaffimed its commitment to enlarge thescope and acoelerate the pace of divestiture, and to institutonalie the reforms necesaly toaccelerate privatization. A team comprised of staff fom the Commercialization Division of theTreasury and the privatization unit of the Ministry of Industries will act as the technicalseetariat. Advice and expertise from international accounting and imestment banking firms willbe provided as necessary. Privatization, however, needs to be pursued in an open trade regime.Prefential trade arrangements granted to new private owners would undermine severelyeicienc gains from privatization. Over the next two yeas, the Government needs to:(i) accelerate pnvatization; (ii) impose hard budgetar constraints on those public enterprises notto be privatized immediately and improve monitoring by the Publc Enterprise Divsion of theTreasur, (iu) increase the autonomy and improve the reguatory envim nt of the utility andtrasport sectors to facilitate private sector entry, and (iv) further improwv the efficiency andprofitability of the two state-owned banks through greater autnomy and eventual pivatiaon.
Z07 With respect to accelerating privatization, a primary objective is to increase theefficiency of resource use in manufacturing services and other sectors through increasedcompetition. The divestiture guidelines are being revied to facilitate the complete divestiture ofmost commercial enterprise by the end of 1995. The Gonmment will need to deal with thelabor redundancies associated with privatization in a manner consistent with the dual objectives ofimproving eficienc and welfar Retrenchment costs should be fuly taken into account in atraparent manner in the Government's financial program for the consolidated public sector.The cost of compensating all excess labor is estimated at 1.6% of GDP, to be covered through
It Extensive background work on this subject is underway in the contex of the preparationof the proposed Second Economic Restucturing Credit (ERC-II) and sector work anagriculture
1S -
the proeeds of pritization, reduced budgetay transfe to state-owned enterpres and, ifnecessa, offsetting meveue measures.
2.08 Public utilities and Air Lanka, the Sri Lanka Railwa (SLR), CWE (the largeststate-owned tradig company), Ceylon Shipping Corporation, the state plantations, the sugrcompuies and the cement companies have been responsible for more than 80% of the totalbudgetay deficits originating from the public enterprise sector. The Government agrees thatCWE should be fully divested to allow increased competition in food staples and is curentlyworking with IDA and other donors on a plan to dhest the enterprise. Privatization of thecement plants located outside the security zone and the sugar companies is advancing. TNocement plants are currently open for tender, while tenders for two sugar companies have recentlybeen completed with the assistance of the Asian Development Bank (ADB). Simarly, CqyonShipping Lines, a subsidiary of Ceylon Shipping Corporation, bas recently been privatized. TheGovernment recently agreed to explore options to privatize Air anka, with help from thenternational Fmance Corporation (FC), and it is currently renewmg Air LankaT s plans to
purchase sevral large aircraft
2.09 At the same time that an accelerated divestiture program is beig implemented,steps need to be taken to impose a hard budget constraint for enterprises that are not to beprivatized immediately or are likely to remain in the public sector for an extended period. Initilsuccess in 1992 in reducing losses and improving yields from the state plantation sub-sectorthrough the transfer of management to prvate sector has paved the way for increased privatesector participation. Tbe ment is now discussing with priate management companies thecanditios for long-term quasi-lease arrangements that approimate the economic life ofivestment in the sector. Full transfer of plantation management and risk to the private sector isessetial to improve effiiency economic performance of the plantation sector. The Govnmntalso plans to complete the privatization of the rmaining 50% of the transport-related assets ofthe Central Transport Board before the end of 1993 and to deregulate bus fares. A timelyimplementation of these policies wil be important.
2.10 Substantial increases in electrcity tariffs and restructuring of electicity pricing arenecesary to address the alarming financial position of CEB and to reduce the implicit subsidy onhousehold consumption which is done at the expese of industry. Implementation of this veressential policy measure has proven to be ver dificult so far. Similrly, the Governent hasbeen rductant to address ineiciencies arising from pricing, imports and distribution of petoleumproducts A speedy implmentation of the required tariff adjustments for CEB is essential toaddress its severe financial ibal and improve efficiency. The recently announced 30%incre is, hence, a welcome first step, but further increases are still needed.
2.11 The autonomy of public enterprises in decision-making should be reinforced, andall Government interventions in these companies, particularly on investment and pricing decisions,should be preented and agreed by Parliament and be made explicit in the budget. This measureis necesay to reduce Government interference in commercial decision-making at the remainingstate-owned enterpres Specific resucturing crteria are being drawn up for the SLR, the twoelecicity companies, Air Lanka and the Petroleum Corporation, to include a timetable forincesing internal cash generation and return on assets, and quantitative targets for transfers andborowing from the budget and the banking system. Action plans for the rationalization and/or
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dvestture of the public utihties and tsport companies and for regulatoqy reform need to beprepared.
2.12 Re g the role of the two large and Inefficient state-owned banks is criticalfor pmvate sector development. Even though the market share of the state-owned commercibanks has been declining, they are market leaders in a segmented market. Privatization of thetwo state-owned commercial bank should become an immediate policy objective. TheGovement is Implementig a plan of short-term actions to address key issues in debt recovetylegislation and central bank superision. However, incased competition and reduced stateinter in the bankdng sector can only be achieved when ownesip, management and riskare fidly transferred to the private sector.
B. Publ Expeuditure Ratiolization 2
2.13 Rationalization of public expenditures is important for both prnvate sectordevelopment and poverty reduction. The main areas where pubLic expenditures could berationalized and reduced over the next few years are the Public Investment Program (PIP), bothon- and off-budget, the civil servce wage bill and the safety-net programs.
X14 The Bank is currently undertaking a review of public expenditures. Prellminaiyanaysis suggests that the PIP includes a number of large projects with doubtful coomic.benefit These require thorough review and scrutiny. For example, the cancellation ormodification of the public investment projects for Air Lanka, the Kalu Ganga irrigation scheme,the purchase of some 5,000 semi-assembled buses and investments for the SLR electrification andextensions are likely to substantially improve the aggregate return on the PIP, and free upresources for use by higher priority public projects and by the private sector.
2.15 On the other hand, expenditures for inruct rehabilitation and operationsand maintenance (0 & M) need to be incrad. 0 & M has been particularly inadequate for:rads, water supply, irrigaton, education and health, al beig cnticd for private sectordevelopment and pov reduction. Rehabilitation and maintenance of existing infrastructure areWr more needed, and are prudent alternatives to new inestment. Along with higher financialresources, the planning and execution of maintenance also needs improvement.
2.16 Rising public sector wage bil present an important potential source of budgetaryinstability. A full solution to the problem calls for a comprehensive reform of publicadminration over the medium-tem. Such a reform would need to include a thorough overhaulof the Government's pay and employment policies and a reassessment of the size and functions ofthe civfl servce in light of the changing role of the public sector. Efficiency gains in the civilservice will also be an important determinant of the improvement in the quality of the PIP. Inthe short-term, some initial steps could be taken to contain the growth in the wage bill bypreventing further increases in the wages and pension benefits and imposing a freeze onrecruitment of lower ranidng civil servants, including teachers and health workers. Containing the
iRecommendatons in this area are based on work being undertakn in the context of thepeparation of ERC-I and on a recent public aependiture review mission.
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number of civi setvants is parcularly important, since the i_ne in the wage bfll has takenplace despite a decline in average real wages in the public sector.
2.17 Sri Lanka spends some 2.5% of GDP on safety-net programs. While the objecdveof these programs is to help reduce poverty, there are a number of seious problems concerningthe poor targeting and efficiency of these programs. A careful reasment of these programswould not only help ensure that the truly poor benefit from the progams, but could also consevefinacial resources. A more detailed review of the various safety-net programs, their problemsand recommendations for possible resctung is contained in Chapter 3.
HI REFORM OF THE TAX AND TRADE REGIME
2.18 As noted in Chapter 1, although Sri Lans tax effort (19% of GDP) comparesfavorably with other developing countries, serious inefficiencies resulting from the tax structueremain. Whie some initial steps in reducig the e have been taken during 1990-92, astro refom effort is needed over the next 2-3 yeam The main items of the tax reformageda are: (i) ratioaliation of indirect taxation by introducing a VAT and rationalizaton ofthe excise duty egime; (ii) reform of corporate and personal income taxes; and(ihi) izan of the tax incentives. Tax and trade reforms (see Section V below) will needto be implmented in line with the stabilization program, and the overall tax and trade reformpackage would need to be designed in a manner so as to ensure revenue neutrality.
A. Indhrc Ta_tion
2.19 Implementation of a VAT is the main priority in the tax reform agenda. AnInstitutional Development Fund (IMF) grant is supporting a core group of VAT experts who arehelping with the admistrative measures. The Government, with Bank and IMF assistance isworkingon the covrage of the proposed VAT, the nature of the base, the scope of theexemptions, the treatment of small businesses and the rate structure The IMF has recommendedan imvoe-opeated, destination4based VAT with a uniform rate. The VAT could be introducedas eary as 1994.
2.20 Introduction of the VAT should obviate the need to impose excise taxes on a widerange of products These taxes should be confined to high revenue items such as tobacco, liquorand petroleum products. The legislation governing the exie duties should be revised to reduceabuse. The Gosernnt plans to introduce reforms of the excie tax with the 1994 budget
3L Cwpoate ad P1rso Iwome Tax
2.21 Confekp_ and Euu The pervive use of tax exemptions is a majorsouwe of revenue age and distorted incentives. Ts one prioty reform ar whereprogress has not been very encouragin The Government needs to confine the objectives andfunctiom of the Board of Investment (BOI) to investment prmotion and fcilitation, asrecomrended by the Foreign Investment Advsory Services (FIAS), rather than as the source forgranting tax eemptioms. AD enterprises with BOI (or GCEC) status should be granted a uniquetax identification number (FIN) and be required to fle annual tax returns, starting with the 1993fiscal year, inespect of whether they have taxable income in a gien year. The corporate TIN
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would help identify the transactions of ail firms, including international ones involing goods andthe flow of funds. Preshipment inspecion serices could be used to monitor leakage into thedomestlc market of goods allowed into the country free of taxes for purposes of manufctigeCports Existing tax holidays should not be extended beyond their initial pe New taxincentives, if at all granted, should come into effect from the first year of operation of theenterprise rather than be linked to first year of profit, and be available only to exporting ventures.Mhe Government should also review the coverage and duration of tax incentives, and a reducedtax rate be applied only to export ventues in a nondicretionary manner.
2.22 Corporat Taxtio. 'Me marginal effective tax rate in the manufacturing sector,which ranges from 37% to 52%, is comparatively high by international standards. However, it isnegated for the most part by the pervasive tax incentives There is a need to reduce themaximum corporate tax rate to 35%, inclusive of al surcharges, while also epanding the tax baseby reducing and eventually eliminating tax exemptions. To reduce the risk of a revenue shorallin the near term, the rate reductions will need to be introduced in phases. For 1993, themaximum corporate tax rate is down to 40%. The next step is to establish a unified corporateand personal income tax rate of 35%, exclusive of surcharges, to be introduced with the 1994budget. The surcharges and levies should be eliminated with the intrduction of the 1995 budget,a step that should bring the rate to 35%.
223 Personal Taxatlo Presently, the maxdmum personal income tax rate is 35%. Thesurcharges, however, need to be eliminated in line with the corporate tax reforn, as equityconsiderations require that the taxes have the same rate across tax objects at similar levels ofincome.
IV. TRADE REFORM AND THE DEREGULATION OF ECONOMIC 4CT1VTO Y
224 Sri Lanka has already taken important first steps to ensure an open, market-frindly envionment for private sector activity through trade liberalization and dereplation.Neverteless, the presence of substantial trade protection, especially in agriculture, and theresulting anti-export bias suggests the need to push ahead with further trade reforms. Inpartcula, the distortionary role of NTBs need to be substantially curtailed.
225 The main objecdves of the trade reform would be to reduce the lvel anddispersion of protection, and to reduce and eventually eliminate the anti-export bias of the traderegime
A. Rdwo of the Import Regle
2.26 The ditnbution of tariffs should be further consolidated by raisng zero duties to10% and reducing the maximum rate on the four-band tarifl so that, in 1995, there wfl be athree4band rate with a maxdmum tariff of 35%. The Govemment should ensure that thesereform are consistent with GA[T obligations, and announce the policy for facilitating pnvatesector adjutmen he EDB-dedicated import levy should also be abolished.
227 Import certification, by which the line minstries determine the tariff rate to beapphed on specific import consignments, should be discontinued. Certifications designed to
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permit eporters to acquire inputs for epor actities at wodd prices should be consolidatedinto the duty drawback system in Apil Mme pracdoe of granting waivers administratively shouldbe streamlined.
228 As a part of ongoing reform effort, the Govermuent has been replacing specificduties with ad valorem tarff. Initially the ad valorem rates may not fit wnthin the establishedtariff bandL Higher rates, ranging up to 100%, are being granted for a tansitional period. Adme-boud plan to reduce these tates to the maximum ta shoud be nunced. IbeGovement should replace the import restcto (NTBs) wi an ad valorem t for sugar,rice and other food and milk products Gien the employment implications in sensitive area oflocation of these industnes, a tranitional arrangement ought conit of an agreement that inrportsof sugar, rice and milk be subject to a variable import levy determined on the basis of a specifiedmechanism that reflecs the movement of international prices. A phased program for euminatingthe bonding arrangements for sugar and rice that takes into acoount government concerns withshort-term food security in the war zone, and for lberaliig imports of other staples, should beannounced. As agred under the PFP, the wheat import and distibution monopoly gramted toCWE should be elmiated as soon as posible.
L. Cu Efcmi
229 Me IF and IDA haew supported a GCvement program aimed at revisigCustom policies, simplifying proedures, onation and controls, andcomputerIzing operations. Te results have been le8s impresive than o0aal evisaged. Dutycoectons on 1991 imports implied a weighted aveage tariff of about only 13%, against a"theortical weighted avage of 39%. is discea is only parly explained by the duty-freeimpot associatedw ith exports, certcations and waie. Leakage is significant and mayincrease with the planned simplificatio of the duty drawbac and remission a gn ts Ieresut may be a conflic between facilitation and simpliflCatiOn, on the one hand, and revenuemobilization on the other.
230 To balance revenue geeration and trde facilitation c theGovemment should: (i) move ahead with the plans for contract for the servies of a preshipmentinspection company for a period of three years; and (ii) strengthen the customs reform programWPreshpment inspections would improve revenue collectons by reducing fraud and leakages.Preshipment inspections need to be used for a finite period, providing the opportunity to focus onthe customs reforms to a grter degree than has been possible so far. IDA has provided supportfor setting the tender specifcations and evaluatg bids for a preshipment inspection service
C. lar Reforms
2.31 Deregulation of internal economic aciviy needs to be complemented over themedium-term with an appropriate reform of the laws and pracies that regulate entry, exit andfactor mobility. Reform of the lgal fmeork reulating the formation of companies andbakruptcy is critical to the long-term devlopment of the private sector. Institutionalimprovements in the Dermet of the Registrar of Compnies and in the commercial courts arenecessy to mine the barriers to entry for small busiesses seeking the benefits of
Eit needs to be facilitated by more epeditious and fair procedures for realng
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and distributing the assets of insolvent or defunct companies, while provisions are necessay toallow for the possibility of asset restructuring and rehabilitation of businesses faced withtemporary difficulties. Reforms in this area call for a systematic review of the various underiglaws and retions. Considerable technical assistance may be necessary.
232 The 1987 Fair Trading Act establishes a regulatory framework for competition,including the ivstigation of complaints regarding monopoes mergers and anti-competitivepractices. The vague and all-encompassing charcter of the act could constrain legitimate pmatesector behavior that has been appopate categorized as ucmpetitv PDA has fundedtechnical assistance in this area Based on this analysis, the Government should review the FairTrading Act and define policies to support competition.
2.33 With more than 80o of agricultural iand publically owned, the practices relating tothe alienation of state land are critical to the private sector. The objective is to increse thesupply of land through long-term commercial lease arrangements and allow the development ofland markets Although the land issue is vital to the development of the prvate sector in thelong run, the Government does not have a clear program of reforms in this area. IDA wil helpthe Govemment initiate a small pilot land registration program for rural and urban land.
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3. POVERTY IN SRI LANKA
3.01 Sri Lanka has established an excelent record in social development as evidencedby indicators that compare favorably with much higher income-level economies, especially in termsof life expectancy, infant mortality, school enrolment and adult litercy. However, resource andpolicy constraint threaten to undermine these achievements, wMth deterioration already occumingil some areas (e.g, evidence of rising malnutrition incidence). At the same time, relatively lowincome grwth, especialy the recent stagnation in agriculture, which provides income andemployment to the bulk of the rural poor, raise concern about the sustainability of the povertyalleviation efforts. Clearly, the ability to accelerate and sustain a higher growth rate overall, and astrong growth in agriculture, will be the key determinant of future progress in reducing poverty.Against the backdrop of the recent progress on the adjustment front (Chapter 1) and the priorityareas for further reform that will help Sri Lanka sustain a better gtwth effort (Chapter 2), thischapter looks at the various dimensions of the poverty problem and proposes a policy reformagenda to help Sri Lanka improve its poverty alleviation performance.
L THE NATURE OF POVERTY IN SRI LANKA
3022 Poverty is generally accepted to be muld as measured by a variety ofindicatos A central dimension is income poverty, or income that is too low relative to somedefined norm Other important indicators of human welfare that are correlated with income tosome degree are those related to nutrition, education, health and fertility. Income poverty andthen poverty as revealed by other human welfare indicators are considered below.
A. Ineom Povt
3.03 A number of studies have measured the incidence of inoome povet in Sri Lanka,using an unusually rich data base derived from household surveys conducted since around 1970.3Because of widely different methodologies and defiitions of poverty, and important differences inthe surveys themselves, they do not yield a cohesive picture of the trends in the incidence ofpovey in the past two decades. Nevertheless, they provide useful information for understandingthe nature of poverty.
3.04 Table 3-1 summaizes the basic information from six studies of poverty spanning
The Socio-Eoonomic Surveys of 1969(0 and 1980/81 and the Labor Force andonomic Survey of 1985/86, conducted by the Department of Census and Statistics,
and the Consumer Fmance Surveys of 1978179, 1981/82 and 1986/97, conducted by theCentral BanL Data from the Income and Expenditure Survey of 1990/91, conducted bythe Department of Census and Statistics, have just been released.
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Table 3-1: STUDIES OF ABSOLUTE POVERTY
Year of Source of Definition of Poverty PovertAutbor Estimate Data Line Incideoce a/
AND= 1969/70 Soob-Economlc Monthy househod Income 18% natIonwidSurvey d 1969/O requrd to met minimum caite
needs dnd as Intake fd2.450 cadrIs per day for an adtmate age 29 and PNes for othe ag nd e goups
Vlwsai 01970 S Avee mony pe cOap 43% naronwd,Swvey d 1O60/70 qa R (ood plus non4d" 43% urban
associtd with per capta ntal 44% rural;.780 calos per adut equvet 31% esta.bnIh Is te to be the minmum
(3unare 1978/9 C om Finae Avere mnt per capt food 223% rdsonwkdeSurvey d 197 Vt79 ofd th bottom 40% d 19.4% uban;
Samn 19601 ScooEoomic Poor ha ou those 20.8% nWowis;Sur- 19a 081 atalnlg lSs enW 80% of 24.5% urban;
ded y calbI Ibnake 20.4% rura;as per WHO no"ms (19,30 1339% esttecaloe per adul male age 2099.an pmro do lmSS for ahrag so se gSroups).
Rouse 19865 Laor Force and Poor rs e aml tfoe 23.5% natow ;Sooconomrdc afttang less ta 80% odady 24.3% urba;Survey of 1985186 calob requrements as per WHO 242% rua;
orms (197. 11.7% estte.
Edrlsk4w 197W Coromw Fhna Averap mm" ahtmhod 24% natIrwide;Surey of t1986/87 e o pku nWooo of 10.5% uban;
the bdomt 40% d houselw*19 28.7 rural;rnked aoOOitn to per capit 11.1% et
diets ydg betwn 80% d100% d the 1comn1ded daiycaloft alowarc (defind as 2750calods per day per ad*
~~~~~~~~~~~~~~~n.el oDefne as umber Of poor IndMual as a perenage of total population
oue Th Word Bank
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the petiod from 1969n70 to A986lS7.4 Athough the studis define the 'pr l" differtly,with one exep y estimate the incdene natonwde within a farly narrow ra of 18-24%. The exceptio b the Vsara sudy, whih yielded a much hiher estmte for 196970 thatmay be attributable to the use of a relatvely high calor normL
3.05 Tle studies rveal no conistent pattern as to whether the incidence is higher inrur or uban areas Hover, they do consistently show that pover is lower in estate area (asort of rural 'enclave") thani in rual or urban areas. Me majority of the por in al the studiesreide in rural (incudin estate) are4s, since the pecentage of the total population in urban areashas been firly smal5
3.06 Most of the studies on povert ideniy the attributes that charcteri por.Some common oanes are a higher dependency ratio (the ratio of members of the household notearing any income to those earning some income) on the part of the poor than the non-poor,comption of fewe years of school and higher iiteracy rates for the poor than non-poor, and atendency of heads of poor households to participate in the labor force at higher rates than doheads of non-poor households (probably a reflection of a ower average reservadon wage forheads of poor households). Ihe studies have also generally found that the unemployment rateamong heads of poor households in the labor force was fiy* low (although hihr than that ofth heads of non-poor households), for example, about 6% in the Rouse stud.'
3.07 Thes findings on the labor markt characteristia of heads of poor householdsuggest that inadequate remuneration is a more important factor than uemployment inexplaining poverty, togetier with the higher dependency ratio of poor households It is sbopossible that adult members of poor households other than household heads may have a owerlabor force participation rate and/or a higher unemployment rate than their counterparts in non-poor households. This point requires furither study, as does the question of the importne ofunderemployment in expaining houehold poverty. The Rouse study, for example, found thatheads of poor households had an u mp nt rate of about 15%, as compared with 9.4%for all heads of householis (whae the underemployed were defined as those usually emplcyedindividuals who had workd less than 180 days in the previous 12 months).
The studies are fakily rpresentadve of the type of work that has been carnied out. Agood surey of povert studies up to around 1985 can be found in 'he Impact of PublicPolicy on the Poor in Sd iLank A Study of Poicis Relating to Incomes, Assets andliving Standards and Their Effects on the Poor, 1970-84," by P. . Alallima (unpubihedPh.D. dissertation, Colombo, 19B8). This chapter draws from that work
Acodi to the Preiminay Report of the Income and Expen Survey of 1990/91,the total estimated population in 1990 was 14.1 million, excluding the Northern andEastern province, broken down as follows: urban, 3 miDlion (213%); rural, 10.2 million(72.3%); and estate, 0.9 milion (6.4%).
The Labor Force and Socio-Economic Suvey of 198S/86, on wbich the Rouse study wasbased, defined persons as gmmpye if they had been economically active (employed,actvely looking for work or a dscouraged worker) for a major part of the last 12 monthsand were mostly unemployed during that period.
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3.08 The Bank is conducting further analysis of poverty incidence and depth and of thecharacteristics of the poor in Sri Lanka in the context of the forthcoming Poverty Asemet.Data from the 1985/86 Labor Force and Socioeconomic Survey and the 1990/91 Income andExpenditure Survey is being used for this purpose. This analysis will provide a more up-to-dateassessment of these important issues.
B. Other Indiators of Human Welfare
3.09 To provide a more complete picture of poverty, it is necessa to examine otherkey indicntors of human welfare Table 2-2 presents recent figures from Sri Lanka for severalindicators, as well as the averages for three categories of countries identified in the Bank's WorldDevelopment Reggorte low-income economies; lower-middle-income economies; and middle-income economies. The table consistently shows that, while the Sri Lankan economy is stillclassified as low-income, its population is much better off in terms of the basic indicators offertility, health and education than are the populations of all three groups of countries onaverage. This remarkable achievement undoubtedly reflects the high prwoty and long-standingcommitment to these sectors in public expenditure programs.
3.10 Also impressive is that Sri Lanka has targeted women as wel as men. Whileiliteracy is more prevalent among women than men (17% venus 7%), a reflection of thedifferential school enrollment rates in the past, currentdy boys and girls are enrolled in primaryand secondary education at about the same rates. This successfu effort to educate a greatmajority of women, together with the success in reducing infant mortalty, appear to have paid offhandsomely in terms of an acceleration of the demographic transition: there has been a sharpdecline in the rate of population gowth since 1965, and the current total fertility rate is close tothe level that would lead to a stationary population.
3.11 As pointed out by Pro£ Amartya Sen in a recent article7, the experience of SriLanka (and the neighboring Indian state of Kerala) challenges the often-aired opinion that adeveloping country cannot afford expenditures for health care and education until it is richer andmore financially sound. Sri Lanka promoted literacy and schooling programs early in this century,it massively expanded medical services in the 1940s Poor countries need not wait to get richbefore they can combat mortality and raise hfe expectancy, and achieve fertiity levels close tothose of developed countnes. Education and health care are labor intensive, and these servicescost much less in a cheap labor economy than they do in a wealthier country. Hence, although apoor country has less to spend on these services, it also needs to spend less on them.
3.12 One dimension of human welfare where Sri Lanka has not fared very well isnutrition status of young children. Evidence from several large surveys indicate that, when SriLankan children are compared to the standard international reference group for the measurementof anthropometric nutrition indices (the standards developed by the U.S. National Center forHealth Statistics around 1970, and later endorsed by WHO), the incidence in young children inthe critical age bracket of 6-36 months of both wasting (low weight-for-height, reflecting acutemalnutrition) and stunting (low height-for-age, reflecting chronic malnutrition) is fairly high. Inthe most recent national survey that collected this sort of information, the 1987 Sri Lanka
71 The Economics of Life and Death by Amartya Sen, in Scientific American, May 1993.
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Demographic and Health Survy, it was found that 15.2% of the children aged 6-11 months,31.1% of those aged 12-23 months, and 34.1% of those aged 24-36 months, were stunted. Forwasting, the correspo-ding percentages were 3.9%, 19.3% and 133%. Malnutrition of pregnantwomen also appears to be widespread; in 1985, 28% of all babies had low birth weight, which washigher than the corresponding figure for Pakistan (25%) and somewhat lower than India (30%o)and Bangladesh (31%).
C. Summing Up
3.13 To summarize this brief review of poverty conditions in Sri Lanka, it may be saidthat Sri Lanka has done extraordinarily well in terms of improving its health, education andfertlity indicators In addition to improving welfare directly, these achievements will be ofimmense value to the country in its current striving to become a middle-income countty. On theother hand, a number of studies using a variety of methodologes have shown that about one-fifthto one-fourth of the population may be considered income-poor. This, in turn, may in partexplain relatively high levels of malnutrition in young children (feeding practices could also bepartly responsible). In spite of such malnutrition, infant and chlfd mortality rates are very low byinternational standards, and the most plausible interpretation of these facts is that under-nourished children do not die in large numbers because of the combination of generally goodlevel of education of the mothers (who can thus recognize life-threatening episodes of illness intheir children) and good coverage of government provided, free basic health services.
IL GROWfif HUMAN RESOURCE DEVE:LOMEnT AND s -NE PROGRAMS
3.14 The general strategy that Sri Lanka should follow to alleviate poverty is similar tothat recommended m the World Banlks W oe nor t 1990 and embodies three keyelements: economic grwh human resource development and the provwon of public safety-netprograms for the severely disadvantaged. As compared with cther developing countries, SriLanka has had a strong emphasis on human resource development and safety-net programs. Itsefforts in human resource development have been very successfuL It has been more difficult toassess the value of the safety-net programs.
A. Gmwth Perfor enau
3.15 Despite strong track-record in improving human resources Sri Lanka's growthprformance has been less impresi Total GDP growth since the mid-1960s has beenconsiderably below the average for low-income countries overall (and, in the 1965-80 period,relative to those countries now classified as middle- and lower-middle-income). However, thedifference narrows when growth of per capita GDP, a more meaningful measure of welfare, isused, since Sn Lankas average annual rate of population growth in the 1965-90 penod was about0.5 percent lower than that of all low-income countries (the difference was even higher withrespect to lower-middle-income countries). In terms of per capita GDP, growth in Sri Lankaaveraged 2.2% per year in 1965-80 versus 2.6% for alI low-income countries; the correspondingfigures for 1980-90 were 26% for Sri Lanka and 4.1% for all low-income countries. In all
of World Development Report 1992, Table 28.
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prbablity, th reduction in Sri Lana's population growth rate reflect the successe in healthand educaton.'
3.16 Table 3.2 also niates that In terms of growth in per capita gross nationalpoduct (GNP), Sri Lanka did as well as the average of all low-inome countries In the 1965-90period (and substantialy better than ether the middle-ncome or lower-middle-icome countries).In genera, per capita GNP i8 a better idicator of a country's welfare than is per capita GDP,since GNP measures the total domestic and forein value added claimed by residents. On theother hand, the higher growth of per capita GNP in Sri TL aW in 1965-90 as compard with GDPmust reflect remittances frm the may labor emigrants.
3.17 As noted in Chapter 1, eonomic reorms taken after 1989 had a positive impacton gowth: GDP growth accelerated to 6.2% in 1990 and continued at 4.8% in 1991 and 4.1% in1992. At the same time the rate of population growth continues to fal, with the avge rate inthe 1989-2000 period exted to be just 1.1% (Table 3-2) and in the 1992-2025 period about0.9%.1 This progress should enable more of the aggregte inome gains to be translated intoper capita gain
3.18 Sucesl continuation and deepening of the economic refom program are key torapid pot Alleviation (see Chapter 2) If Sri Lanka coul for examplfs, sustain an annualaverage rate of growth of GNP of 6% for the 2-year period starting in 1990, its 1990 per capitaGNP of US$470 would reach about US$1,250 in today's dollars by the end of the peiod. An_inrase of this magitude would signifantly reduce povety. Ihe impact on poverty would be
more pronounced the better the evolution of income distrbutiao. A recent study of fIur SouthAsian countries (India, Pakistan, Bangldesh and Sn Lanka) and one East Asian country(Indonesia) eam ed the relationship between the speed of GDP growth and changes in incomedistribution from thy eady 1950s to the late 1980Yu While the data on income distribution areweak, the study shows that, in general, periods of rapid GDP growth have been accompanied byimprovements in income distribution, while perk - of slow or negativ GDP growth have led to aworning income ditibution (the study measurw chnges in income distribution using twodfferent indators-the ii cefficint and the shae of the poorest 40% in total income).nThe same study abo found a strong direct relationship betwen growth in per capita GDP andgowth in real wages of unskld woers: real wes tended to decle when per capita GDP
i The widespread safet-net programs may have conttibuted to accelerating thedemogaphic transition by provding a sense of old-ge security that reduced the desiredfamily size.
J Ihe long-term forecast of the Population Reference Bureau, July 1992.
Gustav F. Papanekl, Mhe Effect of Government Intervention on Growth and Equity:Lessons from Southern Asia, in he State and Maret i Develooment Rivalby oraymyn.Z Louis Putterman and Dietrich Rusdmey (eds.), 1992.
v21 The study alo found that growth was generaly faster when the countries followed moremarket-oriented strategies than when they followed more dirigiste ones.
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Tble. 3- SRI LANKA AND OTHER LOWER AND MDDLE-INCOME COUNTRIES.A COMPARISON OF SOME BASIC INDICATORS
Low-income Ltwer Middle- Income
Indicatots SniLanke Eoonomiae Income Ewoomicsa Bixioea
GNP Per Capita, 1990 (US$) 470 350 1,530 Z2220
Average Annual Rate of 29 2.9 1.5 2.2Growth of GNP Per Capita,1965-90 (Percent)
Sri Lanka is classified as a low-income economy in Wodd Bank statisticu8 Weighted averages.' Excluding China and India
SGun Worfd Deveopm R 1992 The Wod Bank
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roeslowly (1% or less) or declined, andse more than 1% a ytawhenper capta GDPmmmore than 2% a year.
3.19 The study cautions, howeve, that the lnk between grw in per capita GDP andreal wages can break down ff growth is capital-intesive In that case t demand fr unsktedlabor can expand only dowly even if gwwth in per capita income is rapid. Since Sri Lanka is alabor-abundant economy, capital-intensive growth could only ocur If Conmt policiesartificially raise the price of labor relative to capital beyond its effcient level In Implemntingthe agenda for economic reform descibed in Chapter 2, Sri LTank should give high priority topolicy and regulatory reforms that ensure an efficient price of labor relative to capitaLSpecifically, there is a need to: (i) revising regulations and defto Govenment intervention thatraise the price of labor to firms, for example, by makdng it difficult for firm to dismiss woers orby creating paid and unpaid leave entitlements that are unusualy geerous by intenationalstandards; (ii) within tax and trade reform, avoiding reducing the effective rates of taxation anddecreasing the tariffs on capital goods at a rate faster than that for other categories of imports;(iii) not making credit at subsidized rates available to public enterprises for financing theformation of fixed capital; and (iv) enforcing repayment of loan.
B. Emeging Issues in Education and Heath
3.20 To sustain Sri Lanka's good performance in education and health, the Gonmentneeds to continue emphasizing health and education in its public expenditure pgram and shouldallocate funds in line with carel defined priorities. In the case of health, formulation of asuitable regulatory framework for private sector acvitiea important
3.21 Edffo Total Government expenditure on education as a percentage of GDP,exluding transfers under the Mid-Day Meal Program, declined from a peak of 32% in 1989 to2.5% in 1991 and 2.3% in 1992. The latter is low compared with a number of other Asiancountries. In the anticipated constrained fical environment it is imperative that funds be spentwiselY. A number of important issues require attention. (i) In 1992 salaries constituted 97% ofthe recurrent education expenditure of the provinces, which now run most of the generaleducation schools. Uttle room is left for quality-enhancing expenditures such as instrucdonalmaterials and repairs and maintenance of facilties. (ii) There is a wide discrepancy in theresource allocation per student between small and large schools, which Is only partly explained bythe fact that larger schools tend to have a higher proportio of students at the secondary klveL(iii) There are also wide discrepancies in the allocation of education resources across provncesIn general, poorer provinces have proportionally more unqualfied tachem and higher teachershortages, and they tend to spend much less on instructional and teaching materials. (iv) Thenumber of secondary school teachers (grades 611) has increased very rapidly, from about 64,000in 1985 to almost 89,000 in 1991, with a corresponding decline in the student/teacher ratio at thatlevel from 25.3 in 1985 to 21.1 in 1991, a very low ratio by international standards Ie pimaryschool student/teacher ratio in 1991 was also tow-about 31 (although up from 28.7 in 1985).(v) Although the number of university students is presently relatively low compared with otherlow- and middle-income countries, Government spending on university education in real termsincreased by a high annual rate of 12% in the 1987-92 period and is planned to grow at about 9%a year up to the end of the decade. If the present policy of no cost recovery continues, thisgrowth could crowd out higher priority expenditures on general education.
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3.22 Because of the decline in fertflity, the number of students entering grade 1 hasalready started to fall, an effect that witl cascade up the primary grades (1-5). It will alsogradually reduce the pool of students for secondary schooL These favorable demographic trendsopen up the posstbility of upgrading the quality of general education without incrasing the shareof related spending in GDP. However, upgrading the quality and efficiency of general educationwil require confronting the issues listed above.
3.23 1IaltlF Total Government expenditure on health as a percentage of GDPdeclined from a peak of 1.8% in 1989 to 1.4% in 1991 and 1.6% in 1992; it is exected to beabout 1.5% in 1993. This latter figure is about average as compared with most South Asian andEast Asian countries.- Total (public and private) expenditure on health-related goods andservices as a percentage of GDP was estimated at 3.1% in 1986R97, about average when comparedwith the same group of countries.
3.24 Government health facilities already provide good coverage throughout thecountry. As with education, the decline in ferlity provides an opportunity to use future increasesin per capita Government health expenditure to improve quality. The number of children underfiv - will decline in the 1990s; at the same time, however, those 60 and over will more thandouble, from 1.4 million in 1991 to 2.3 million in 2001. This latter development will increase theburden of diseases with high treatment costs, such as cancer and cardiovascula disease.
3.25 These changes in epidemiological patterns, together with the strong growth ofprivate health services in recent years, call for a thorough polcy review of the sector. Gi thegrowth in private services, a regulatory and superviory framework is needed, but no regulatorybody has been set up. It may also be desirable to redefine the division of labor between thepublic and prinate sectors in both the provision of services and the financing of accesL Forexample, the public sector could concentrate more on preventive care, health education andcommunicable disease control and leave most curative services to the private sector. However,this divsion poses difficult questions about financing access to curative services by the poor ingeneral and by the poor and non-poor in terms of catastroph;: and chronic illness
3.26 A recent Bank review of Govemment health expenditures identified several otherissues: (i) While mortaliq rates continue to decline, the incidence of morbidity from severalpreventable diseases is rising. (ii) The higher level facilities such as teaching and speciizedhospitals and provincial hospitals are overcrowded, while smaller facilities such as district and ruralhospitals are underutilized. Consumers prefer the higher level facilities because the servicesprovided by district and rural hospitals are of insufficient quality. This imbalance could bereduced by providing more adequate funding to the underutilized facilities, which the PIPemphasizes. (iii) There has been a large decline in the ratio of average annual recurrent healthexpenditure to the value of the health capital stock. While it is difficult to determine what levelis adequate, an imbalance may have developed between spending on expanding facilities and onoperations and maintenance. (iv) A particular aspect of (iii) is the clear inadequacy ofexpenditures for maintenance, which in 1990-92 were only about one-third of what was required.
See Charles Griffin, Health Care in Asia A Comparative Study of Cost and Fmancing,'World Bank Regional and Sectoral Studies, Washington, D.C., 1992, Table 4.
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C Safey-Net Proms
3.27 Te Govenment offies an anray of programs for transferring income to certaingroups. 'he main progams, which together spent the equivalent of about 2.5% of GDP in 1992,are described below, along with suggestions for resatruuig them.
3.28 The Poor Relief Food Smp Pom (FSP). Thi program, which accounted for0.7% of GDP in 1992, aims to imnpre the nutritional status of poor households by iceaingtheir disposable income with monthly coupons that can be exchanged for food in specialcooperative stores.
3.29 The .anasalva _ P IS). This program, which accounted for 0.7% of GDPin 1992, has as its basic concept to provide poor households with fixd monthly cash grants for aperiod of two years. This 'breathing space is expected to enable some recipients to setthemselves up as microentepreneurs or to acquire the skills needed to get better paying jobs, andhouseholds can thereby exit poverty. The ISP is being phased in throughout the country insuccesive, geographically-defined 'rounds. A total of 11 rounds is planned; 4 have aleady beenlaunched, and the remaining 7 will be launched within the next seveal yeas. Once the ISP hasbeen started in an area, the FSP is phased out, except that households receiving public assistan(see below) can retai their FSP benefits.
3.30 The monthly grants are fixed at Rs 1,458, comprsng a cash 'consumptionW transferof Rs 1,00C rcleased every month and a 'savin component of Rs 4S8 that households get in alump sum at the end of the two-year period and that is to be used for investment projects. Amonthly grant of Rs 1,458 is farly large by local standards; it is, for example, about nine times theaverage household payment under the FSP (about Rs 167 in 1992). JSP beneficiary householdswere also supposed to get an additional lump sum grant of Rs 25,000 at the end of the two-yearperiod. Because of fiscal constraints this payment has not happened, but a monthly 'interest'payment of Rs 250 per household is being made for the indefinite future to households that havecompleted the two-year period (unless a member of the household get a Government job or ajob in the Government-sponsored 200-garment factory program)
331 Tbe Mid-Da Meal Pa M. DM. program, which accounted for 0.4%of GDP in 1992, is a universal, non-targetd program for all children attedig primary andsenday schooL Its objecives are to improve nutritin sad ire the rturns on educationexpenditure by increasing attendance and student alertness. he program provides a subsidy ofEs 3 per day per child to families of students bringing a meal to shool that meets certin criteriait has to be nutritious and non-wheat flour-based. Te subsidy is given in the form of monthlycoupons that can be redeemed at special cooperative stores (same as the FSP coupons).Teachers make a note of students failing to attnd school or bring a sutable meal, and thecorresponding amounts are deducted from the entitlement at the end of the month.
3.32 TMNurs to the Trol! Needv. Severad programs, accounting for less than 0.1% ofGDP in 1992, fall under this rubricb Since 1989 they have for the most part been managed by theprovices The largest program invlves publc assitance payments to households with incomesof less than Rs 300 per month whose heads of household are disabled, elderly or widows OtherGovernment programs finance custodial care for destitute elderly and orphans and various formsof rebabilitation.
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3.33 -t pRJ d Popu Under this categoty, which accounted for0.6% of GDP In 1992, ae the asstae progrm for famiuies and individuals displaced by theci conflict in the North and East. Ihe Govrment operates 463 camps for displaced persons,prviding dry food rations to the displaced populatons, as wel as to may other displaced peoplehivg outside the camps (some 615,000 tegitered diplae0d prwss live inside and outside thecamps). In addiion, displaced famiies retuning to their orginal place of residence are eligiblefor a range of benefits under the Unified Scheme of Assistance.
3.34 Asseamntof klmm M m array of trasfer programs is impressive giventhe levl of Sri LIans per capita income. bt demonstrates the tradition of helping the weakestsegents of the populadon. At the same time, however, it appears that Sri Lanka has made toobroad a use of safety net progams in the fight against povert, such programs should mainly beviewed as an instrment of last resaort. The present fiscal stringency means, moreover, that evprograms of this nature have to be carefully scrutinized, since they may have a high opportunitycost The FSP, for example, bas not been well-targeted: it stiUl includes many ineligi-blebeneficiaries while ecluding may bona fide potential beneficiaries Given the decline in the realvalue of the benefits per household, it is unclar whether the program is achieving its orginalObjectives.
3.35 In the case of the JSP, there is evidence that the screening of beneficiaries hasbeen better than under the FSP. Howeve, as mentioned, once the two-yea perid is over,benficiaty households are entitled to a payment of Rs 250 per month indeftitely, regardles oftheir economic situation Thi polic to some extent negates the effects of the improvedscreening On the other hand, the paYment of Rs 250 per month does function as a safety net forthose houeholds unable to exit poverty as a result of the JSP but that no longer receive FSPbenefits.
3.36 A lky criterion of the sucoess of the ISP is the proportion of beneficiaryhouseholds able to exit poverty as a result of the progam. The ISP's own defnition of whatedting poverty means is achieving a household income of Rs 1,500 per month. The Women'sBureau of Sri L ank (a nongovernmental oon) nducted a random survey of 299 roundone beneficiar households three months after they had completed the two years Manyhouseholds had ineased ther incomes relative to before the profgam, including a small minorityof about 13% whose incomes rose above the pgam's target of Rs 1,500 per month. Howevoer,some of the apparent gains may bave been the result of inflation, which averaged 12.8% per yearduring round one and/or to undporting of pre-program incomes. On balance, presentevdence indicates that few households will exit poverty as a result of the program and it shouldbe reviewed.
3.37 With regad to the MDMP, it may be argued that the distribution of benefits isregre, at kast at the seondary hool Wel, since secondary enrollment is directly catedwith household income. The nutritiona impact is also dubious, since the daily subsidy issubstantialy belbw the cost of a nutritious meal, and it appears that many teachers are notenfoing hde iddei on meal content (and some may not even be recording students who donot bring meals). Further, it is not clear how the progam has contributed to the decline ina m (absenteeism has been declg since the early 1980s Hence, this program may beyieding few socia benefits per rupee spent (espcally if benefits are weighted in inverseproportion to the income status of bena icris). As in the case of the JSP, the MDMP programshould also be reviewed.
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3.38 The programs grouped above under the label of 'transfers to the truly needy'appear to be seveely underfunded. The Government needs to conduct an in-depth review ofthese programs. It should study the eligibilty criteria and amounts of the entitlements, taldng intoaccount other sources of public assistance for the households (mainly food stamps). At the sametime, it should strengthen accountabflity, especially of the programs devolved to the PovincialCouncis.
339 As to assistance to displaced people, it appears to be generally adequate, but thereare problem The camps were meant to be temporary, but several years after the programstarted the great majority of the families have not been able to return home. Although there areno hard data, the quality of the water and sanitation facilities in many camps is poor. In thecamps outside Colombo, the quality of the housing is very poor and overcrowding rampant. Inthe ar around the camps located in the high-confict areas in the North, whete about half thedisplaced people are, the fighting has disrupted basic health and education services, affecting,inter alia, the displaced population. There are also problems with targeting. many ineligiblepeople are receiving benefits, especially in the Colombo camps. The Government is conducting asurvey to improve the targeting of benefits.
3.40 _w foIU for Restncturln the SafetV-Net . The safety-net programsshould be seen as a package, because of the complementarities among them. Specific reformsmight include:
(i) Ihe MDMP could be restricted to primary school children to reduce the cost andimprove progresity.
(ii) Rescreening of FSP program beneficiares could be caried out immediately inareas where the JSP has not yet arrived. That is, the JSP methods could be usedto prune the rolls of the FSP in the entire country regardless of the phasing ofthe ISP. This measure would reduce the costs and improve progressity. At thesame time, the amount of FSP payments per household could be raised tocompensate for the real decline in value since the program's inception.
(iii) In those areas where the ISP two-year period is over, the open-ended payment ofRs 250 per household per month might be canceled (and the promise of the Rs25,000 grant renounced). Instead, the FSP could be reintroduced with the sameeligibility criteria as in the rest of the country (as suggested in [lij above).
(iv) Tle eligibility cntena and amounts of entitlements under the ansfers to thetruly needy' should be reviewed, and the amounts probably raised.
(v) If , after taking into account the net effect on Govenment spending of the abovesuggested changes, it is concluded that the overall amount of Governmentspending on safety-net programs needs to be further reduced (given the overallfiscal constraint and other spending pnorities), the cuts should come from the JSPprogram. The JSP, if necessary, should be phased out.
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4. THE ECONOMIC OUTLOK ANDEXNERNAL FINANCING REQUJIREMENTS
I MACROECONOMIC TARGM AND POLICIES
4.01 _ k . As indicated in the Government's fifth-year PFP, SriLaka's medium-term macroeconomic objectives are to achieve and maintain a strong rate ofGDP gowth of 6% p.a., reduce the fiscal decit to below 7% of GDP, reduce the externalcurent account deficit to about 5% of GDP and maintain relative price stability, while ensuringthat soci and enironm coucrns are addressd Sri Laks objectives, while ambitious, arefasilbkl With a strong human resource base resulting from 30 years of determined efforts toimprove education and health, and a good naturl resource endowment, Sri Lanka's long-rundevelopment potential is strong. Realizing this full potential has been constrained by annceasisgy costly civil war and the stop-go nature of past policy reform efforts. The medium-
tem prspects, therefore, critically depend upon developments concering the civil war and policyprogress. With sustained peace effos and consistent progress in implementing policy reformsalong the lines dicussed in Chapter 2, Sri Lanka's macroeconomic objecives descnbed above areachievable.
4412 ak d Structaral FoUc YR ef In order to achieve this highgrowth rate, the Goverment realizes that the largest untapped resource is Sri LAnas dynamicprivate sector. The findamental pmiar of its adjustment program is to create an environment thatalows private activity to expand in a sustainable manner. Ihe role of the public sector is beingrcted towad the provision of a stable policy and regulatory environment and pursuit ofGovernment activities that complement private sector activity and investment. A detaied reviewof the medium-term policy agenda was presented in Chapter 2. Below we summarize the keypoits of the policy progam that underle the projectons presented in Secion IL Among themao important tausk to be undertaken are the following
(iJ Sound Macroeconomic Management. A succesful structural adjustment programrequires a stable macroeconomic environment. In Sri Lank, this implies inparticular further progress in reducing the fiscal deficit and improved financialdiscipline in the state-owned enterprise sector. The Government needs to reducethe fiscal deficit to about 66.5% of GDP, mainly through expenditure restraint.Further gains on the renue side are expected to be limited since the current taxeffort of about 19% of GDP is cnierable given Sri L s income leveL Withregrd to public enterpries and other autonomous public agencies, theGovernment needs to ensure that pncimg policies are adequate, cost control isimproved and new investments are carefully screened and prioritized. Improvedfiancial dipline by the broad public sector is crucial to curtail growth in overalllquidity to about 12%-13% p.a, in line with growth and inflation targets.
(ii) Impove Public Expenditure Manaremmf Expenditure restraint is alwas difficlt,particularly when there is a need to increase selected outks to strengthen growth
-34.
prospc by reinrcing the ift e base and preserve gains in povertyalleviation and human capital development Recent improvements in thebudgetty outcome have been large at the expense of public investment which in1992 declined to 6.8% of GDP. In order to meet these development needs, andiace public Iesment to about 9% of GDP, while reducing the fisl defiit,the Govemment needs to restructure curent expenditures along the linesproposed in previous chapter including carl setting of investment priorities,wage restt, expenditure screening for poverty aleviation programs, and, moregenerally, by tapping pivate sector reor and nagement.
(Iii) Am th Incenive Fm In order to achieve the ambitious growthtargets, the imp ent in publc sctor management needs to be complementedby accelerating the implementaton of structral measures designed to increaseextenal and internal competition and efficency in goods and factor markets. Inagiculture, the Governmet needs to make significant progress in elminatingcropping and land-use restrictons, inte picing and trade policies, andifficient marketing by state-owned enterprises. In manufactuing, theGovernment should implement a broad based trade and tariff reform to enhanceefficiency and reduce the anti-eort bias of the trade regime, eliminate direct andindirect bariers to entr and exit, and begin to tackle rigidities in labor legislation.These stutural poleies need to be coupled with a flexible exchange rate policydirected primarily at maintaining eternal competitiveness.
(iv) M l?rdiate Setor hii nd Iuitat. Increased private invetment andsavngs are crucial to increase growth and improve the balance of payments The6% pa. growth target is predicated on increaing the investment to GDP ratio toabout 25%-26%; it is crucial that the 1992 private inmestment effort of 16%-17%of GDP is sustained over the medium-term. Together with the changes in theincentive regime descnrbed above, the trade and foreign exchange liberaliztionmeasures undertaken in recent yea and the Government's privatization effortsshould prmote private ivetment and attract foreign capital. The privatizationeffort if accompanied by apprpriate changes in the regulatory regiWe, will beparticularly important to increase efficien and Inestment in the plantations sub-sctor and in the poiion of tem nions and inrstrucure services.
403 As noted,thnc conflicts, and political violence in the 1980s have been verydetimeal to Sri Lanka's economic performance. Improvments in the political and seuitydsiatio are essential for sustained increase iin priate domestic and foreign investment. If SriLanka I to fufiSll its considerable economic potential, the country needs to experience sustained
IL MACROECONOMIC OUTLAOOK UNDER ADJUSTMENT
404 Sd Lanka's medium-term economic prospects are favorable if the Govenmentsucesfull address the short-term stabilization dalenges and implements stmrtural reformsta pmote prvate sector activity and incease efficiency as described above. The imprvedfinnci poicies of the public sector would reduce public sector browing and fee resources for
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private sector activty. Private sector activty would also be enhanced and made, moe efficien bythe rapid imple tati of the stutural reforms directed at increaing eterm and hImalcompetition and enhancing efficien in resource aoaion Rece gains in preserving eqportcompeftfiveness wod be reifored by, among other tg, the plementation of the trade andtarff reorm that reduces the antieprt bias in the trade egime and integrates agriculture intothe already successful export drive of maauring. Prte investment and extera capitalinflows would remain strong as rates of return stregthen Table 4.1 Illustrates how the maineconomic indicators could perform should the Goverment implement forcefully its adjusment
4105 Under these favorable assumpons, real growth would increase grdually to about6% per yea, while inflation would decline to an annual averg about 6% by 1995. Themanufacturing sector, Pat export Iduste, i eected to continue its present growthmomtum of 8%-9% p.a Agricuture growth perfomance would gradually impre from 0.5%p.a. on average during 1985-92 to about 2%-3% p.a. over the medium-term because ofimprovements in the plantation subsetor resulting from private sector management, and in thesmallhlder subsector, resutng from the eliminatio of the cropping and land use restictions,and chages in the inentiv regim Increasd investment and exports are expcted to be themain sources of growth on the demand ide Export growth i projected to average sine 7%4Wop.a. in volume terms and to be broad- based, althou fh garments will remain the leadig sector.
4.06 Sri Lanka has not alvays been ab' to avoid ma mic di a, andinflation has at times ereeded low two-digit figures. Recent pocy decisios in eady 1993,particulady in the area of public s vin put Sri lanka at risk of repeating pastmacroeconomic imbaIac Unless the Governmettakcorctive measures immediately torestore fisal discipline and fnancial stability, the potental for accelerating inflation and the re-emergence of macrnconmi imbalances is reat. Fiscal discipline is crucial to achie the hightet for private investment, sice public sector domestic borrowing has to be reduced to releasescam re sources to the private sector.
4.07 Monetay policy needs to ensure that growth in overall lquidity is consitet withthe targets for output grwvth and i on. The annual rate of growth of the money supplyshoud be reduced from 17.4% in 1992 to about 12%-13% by 1996. he expected dedine inpubic sector borrowing is cucial to achivig this tget since both the imprvmet in the netforeig assets of the banling system and the demand for credit by the private sector aising fromthe expected high lvel of vtment will put exansionar pressure on the mone supply.Continuous monitordg of the lquidity situation and its causal factors and prompt implmentationof cowective measures are crucial to achving the planed price stability.
4.0 Saving rates wmi need to iease ommeuratel with the inestnt effort forthe latter to be sustainable. Gross domestic saving is projected to rie by about 3% of GDP by1995 largely because of the expcted incas in government saving. A gadual increase in privateaving as a result of higher growth and fincial and extemal sector reforms will further increasedomestic and naond savg and reduce the dependency on oreign savings in maintaing a highleve of inestment.
a] Colombo Consumers' Price inde.b/ Debt service/eamings from merchandise expors and seWvices.cl Medium and Long-term central government and government guaranteed debt, Including Fund.d/ Exports and Imports Include goods and non-factor services.
Ratios are in current prices; growth rates are In constant prices.el bocluding official transfer payments (net).U Growth of annual average of Real Effective Exchange Rate
Sowures Sri Laa auh#ue; adMafSf etiat
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IL E OJ AM EKTERNAL N&bNMM REOE_
4.09 The EOMt cluding unepected extera shocks, Sri Iankas externalposition woud strengthen if the adjustment program is implemented forcefiully. The ilustrativescenario indicates that current account deficit would decline to about 5.0% of GDP, whfle theoverall balance of payments would register small surpluses. The prticipal assumptions underlyingthis favorable outcome is prudent demand management policis that restrict the expansion ofimports and the implementation of stuctural measures descnrbed above to promote exports.
4.10 Manufactures are expected to be the most dynamic export sector, but traditionalexports wil also regain an upward trend. Tea and rubber exports in particular should grow as theprivate management strengthens the plantation subsector. Imports wil grow more slowly taexs but will increase faster than of GDP because of the strong dependence of exports onimported inputs Despite the expected increase in service payments following the recentiberaliatx of travel and other service transactions, the service account is expected to improve
from an expansion in tourism and higher workers' remittances.
4.11 Ea FlNDcl Reautreumnts and tle Cautal Acco Under theadjustment scenario dicussed above, Sri LXnka's external financing requirements will be stable ataround US$1.2 billion pa. throughout the projection periol. Ihis level of extnal financingrequirements is within the range of expected donor commitment and private capital flows, andthe need for commerci borrowing seems unlikely. The structure of Sri Lankas capital accowtis beinnig to change. The share of private capital inflows has incased sharply, including FDLThis trend should boost the availabflity of extemal resources. Together with the strong traditionalsupport from official donors, the private inflows will yield small surpluses in the balance ofpayments. As a result, gross official reserves will rise to about four months of imports by 1995,facilitating furthleralzation in the external sector.
4.12 While avaity of xernal financing has been adequate, its effectie utflizatin isan important emerging issue. Extemal assistance committed but undisbursed rose to about USS2,195 million at end 1992 as the public sectors' capacity to implement the development programbecame overstretched. Given the uncertain prospects for continumg inreases in aid transfers as aresult of rising competing demands for these resources elsewhere (eg, the FSU, Africa, etc.), SriLanas suess in atracting increased aid flows would depend increasingly on ir;povements intheir utilizationL
IV. RISKS AND
4.13 Despite Sri Lanks strong potential, the growth scenaDrio presented above facessubstantial risks These risks can be broadly grouped into two categories: domestic !isks andexternal risks Domestic unrest is a vemy real threat that influences investment decis ons as itaffects perceived investment risks and returs. Political populsm also introduces uicertainty as itmay direcwy affect macroeconomic disipline and project performance. On the external front, therisks in prospects are linked to adverse developments related to international prices, export andfinancial markes
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Table 4-2: EXTERNAL FINANCIAL REQUIREMENTS(In million of SDR)
SOL.' Dat pd*~ by On S "LW aughof IMF and Staff pron
'39
A. Doomsesi Risk
4.14 Slips In the policy rea, either related to a wonening of the cvil unrest or thegovernance problem, pose ccia treats to macroonomic prospects The past fperienc Ofstop-go refom Mustrate this rhL In the eet that the implementation of the reform progrmfalte, Sn Lans economic performnce would be c abl weake than that presented inthe adjustment scos t is sitaltentiv scario (see Table 4-3) suggest that withoutapp rpra poliy reforms, macroeconomic Imbalances would weaken and economic growth coulddeclne to arund 3% pa. Tis lower growth path would have serious adverse implicatiom foremployment and por.
Takbl 43: ILLUSTRATIVE ALTERNATIVE SCENARIOS-SELCIED KEY UIDICATORS
FY93-96
Adjustmet Scenario Policy Slippage Scenario
Real GDP Growth (% p.a) 5.8 33Per Capta Growth (% pa) 4.7 22Inetment (% of GDP) 24.5 20.0Naoti Savintg (% of GDP) 20.5 14.0
B. Maabnc
Current Account Deicit 4.4 6.0Budget Deficit 7.0 10.0Infton 7.0 12.0Reser (month of imprts) 4.0 2.5
SourCe: Wold Bank Prjecdon.
B. Exten Ri s8
4.15 External shoclb, such as unexpected changes in international goods prices, intertand exchane rates, or advese d opments in ort popects, are another potential source ofriss At present, fluctuations m intenatonal Interest rates have only a limited impact, as most ofthe countrys extena debt is on concessinal tm with fixed, higl favorable lending rates.Neve lss, Sri Lanks vubilty to interationa interest rates is increasing with theexpanion in foreign portfolio investments. Sri anika is vulnerable to exchang rate fluctuatas most of its exports are denominated in U.S dollars while the currency composition of its debtservice payments reflects a more divse portfolio of Government and Govenment-guaranteeddebt. Chages in intemationad commodity markets, partcula for tea, garments, petroleum,
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wheat and rice, are the major sources of exogenous shockL In paticudar, the garment export sub-sectr, which recorded its highest growth in the recent past, is subject to a quota system, andchanges in the Multifiber Arrangement (MFA) could affect Sri Lanka's exports significantly.
4.16 A 10% deterIoration in the price of garment exports will inrea the currentaccount deficit by about US$88 million, or 1.0% of GDP. Simiarly, a 20% reduction in the priceof tea exports will increase the external current account deficit by about US$84 million, or 1.0%of GDP, while a 20% increase in petroleum import prices will increse the current account deficitby about US $66 million, or 0.7% of GDP. If such eventualities occur, achievement of highgrowth wil depend heavily on the degree and speed of the Government's response in terms ofcompensatory policy reforms. Wie the adverse consequences of small, temporary disturbancescould be absorbed through reserve drawdown, large external shocks would call for an appropriateresponse in terms of a strengthened macroeconomic management and structural policy reforms.Over the longer term, Sri Lanka needs to minimize these risks through export diversification.
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STATISTICALANNEX OF TABLES
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STATISTICAL ANNEX OF TABLES
TABLE NOS. T1TE
1.1: Value-Added Growth Rates of Major Scoots
1.2: Key Economic Variables 1984-1992
1.3: Sectoral Composition and Inacreae in Gross National Product 1980.1992
1.4: Macroecnomic Balances 1985-1992
1.5:E on Gros Domestic Product
1.6: Composition of Gros Capital Formation
1.7: Composition of Public Sector Iestmen
1S. Sectoral Growth Rates and Relative Contrbution to Ince e
1.9. Trns in Principa Agiulual Crops
1.10: Composition of Industria Production
1.11: Performace In the Public Sector and the Prvate Sector
1.12: Annual Rainfall Index
1.13: Drought Impact
1.14: Sumniay of Centrl Goenm t Fica Operadons, 1987-1993
1.15: Composition of Gova ment Editue
1.16. Composition of Govrmnt Revenue as a Ratio of GDP
1.17: Composition of Govenmet Revenue as a Percentage of TotalRevenue
1.1& Monetary Developments
1.19: Relative Contribution to Monetary Exansion by Causal Facton
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TABLE NOS. TMTE
1.2& fmal Bank Advances to the Private Sector oad PubhcCorporations by Purpose
I21: Credit to Public Corporations
1.22 Compositon of the Fnancial System
1.23: Temuty Bill Markets
1.24: Cotombo Consumen' Price Itdex - CCPI
1.2: Namnal and Real Wage Rate indices
126 Balance of Payments
1.27: EpOrt
1.2& of Expors
1.29 Expt Diesifiction bdex
1.3& Texdles and GwmentsCotbhig
131: Composition of Textiles and amets Exports
132: Real Effectie Exchange Rate Index
133: Comparatve Base Wae Rates Factoiy Workes
1.34: Cost of Capital
1.35: The Public bnvestment Proam in 1992-1996
136: Shae of Detailed n the Public Invtment Proam
137: Cntal Bank Refinance Facilities
TABLE 1.1: VALUE-ADDED GROWTH RATES OF MAJOR SECTORS(Percenftag %)
Private 100.0 75.7 78.9 92.4 94.2 93.9 126.0 135.1 147.6- Comparable data for 1992 are not yet available due to privatlsation of the management of estates ownedby the JEDB and SLSPC In July 1992.- Investent data of the pubic corporaton sector and te prhate sor are not availa separately In 1992.
Petrum Products US S Mn. 87.92 71.23 62.31 98.06 79.50 6328Pdrc $ew ML ton 138.88 103.69 106.76 15662 151.89 154.13Volwme, 000 ML ton 64242 6865 58360 6250 523.20 410.10
Procesed diamonds UsS MIS 39.57 51.21 90.34 91.87 67.87 107.07Other ndusti products U8$ Mn. 113.65 142.60 148.07 217.53 275.04 35883
Vai St.e -in Volume Value Ne Unit V" ain v gi. w V: u .tlcs .. ......TOt*EX; Indkf idex Ttl 1em : Pried - k ;:la~$DRMmm !b i85vu10 198$um100 19065a10 SORIPlecp BO Mn. % ie.ir1$1U L-( 0-O