| |
Background Sri Lanka initiated an economic liberalization programme in 1977 that laid the foundation for far reaching reforms in almost all spheres of economic activity. It marked a radical departure from an inward-looking, controlled-economy approach to a liberalized, export-oriented strategy. The policy programme included many of the standards reforms of a structural adjustment programme, including liberalization of trade and payments, rationalization of public expenditure, de-control of prices and interest rates, promotion of private sector development, foreign investment promotion, and financial sector reforms. Although during the following decade the reforms transformed the Sri Lankan economy moving it away from a predominantly agriculture base to an increasingly industrialised and services base, a second phase of reforms was felt to be necessary in the latter part of the 1980s to rejuvenate a flagging economy. The "second phase" of the liberalization programme, announced in 1989, was geared to further relaxing remaining restrictions and constraints in the economy. In particular, it was intended primarily to create an economic environment more conducive to the efficient operation of the private sector. The reforms introduced in 1989 revolved around providing further incentives to foreign investment, relaxing restrictions on foreign exchange, introducing additional foreign currency banking facilities, and the further easing of import and licensing requirements with respect to trade and industry. After more than two decades of policy reform, Sri Lanka is one of the most open and market-oriented economies in the developing world. However, nearly two decades of civil conflict have also taken a toll on the country’s economy. Defence expenditures continue to absorb, on average, nearly 5 per cent of GDP per annum, while the country has been unable to shore up investor confidence sufficiently to raise its volume of foreign direct investment over the years. Although improvements in macroeconomic management were recorded, they proved to be transitory as the government continued to grapple with high fiscal deficits. On the political front, the prospects for peace have proven elusive. Nevertheless, while economic policymaking has to continue under existing constraints, the Sri Lankan economy also has to be geared to meet the challenges that will arise in the event of peace. In the eventuality of peace, it is often argued that Sri Lanka can immediately move to a higher growth trajectory of 7-8 per cent. While that prospect certainly exists, what is of some dispute is the time-frame in which the country will achieve accelerated growth. During a more than likely period of adjustment, factors of production—capital, land and labour—will have to be reallocated and rehabilitated. A major factor that will come into play here is the country’s ability to not only attract foreign investment—both official and private—but also the extent to which the domestic economy is geared to absorb additional capital without destabilising macroeconomic management. Research Programme
Macroeconomic policy issues have been at the forefront of the Institute of Policy Studies’ research agenda. While much of the early work concentrated on the immediate problems of structural adjustment—the performance in the balance of payments, fiscal policy, and inflation, the research agenda expanded in the recent years to include the analysis of wider issues such as the implications of liberalizing the capital account, the economic cost of the war, etc. The research agenda on macroeconomic policy will continue to apply this broad-based approach.
The research programme under the Macroeconomic Policy Unit initiated a study reviewing the process, constraints and future challenges of Sri Lanka’s economic liberalization programme. The study was conducted during a period of 6 months (July to December, 2001), and its principal aim was to flesh out the details relevant to the rest of the research programme:
Macroeconomic management is a critical factor not only in generating donor assistance, but also in Aid Effectiveness and Utilization.
-
A well-designed privatization programme not only assists in rationalizing public finances, but can also support Capital Market Development.
-
Pension Reform should be a key factor in any future attempt at rationalizing public finances, and can again be employed as an effective tool to invigorate Sri Lanka’s flagging capital market.
-
Success in financial sector reforms is dependent on achieving macroeconomic stability. High and volatile inflation increases the risk for both lenders and borrowers, and complicates the pricing of financial instruments. A clearer perception of the Determinants of Inflation in Sri Lanka will provide a wider understanding of developments in monetary policy management.
The following themes were identified as the key areas for research over the next 2-3 years:
Economic Reform and Adjustment: What has Sri Lanka Achieved?
Rationale The performance of the Sri Lankan economy in the first decade after the implementation of a wide ranging package of reforms has been well documented. What is less clear is the pace of reforms, and their implementation and impact on economic performance in the second decade of liberalization. Sri Lanka has made considerable strides in diversifying its production base away from agriculture towards industrial and service sector led growth. However, industrial sector expansion has been restrained in more recent years, which is reflected in the limited diversification of Sri Lanka’s export base despite two decades of export-oriented growth. The lack of dynamism in industrial export sector growth underlines Sri Lanka’s GDP growth performance over the last decade. The significant improvements in the arena of trade liberalization, financial deregulation, and macroeconomic management have not been translated into achieving a sustained growth rate of over 6 per cent per annum—a growth rate that is, arguably, well within Sri Lanka’s grasp. Objectives Why has the economy failed to produce a higher level of dynamism? Has the reform agenda stalled? Or has there even been a reversal of the liberalization agenda? The proposed study will detail the implementation of Sri Lanka’s reform agenda in the areas of trade and payments, industrial policy, privatization and deregulation, and financial sector reforms. It will then attempt to identify the impact of reforms on macroeconomic performance in generating savings and investment in both the public and private sectors, and in doing so, identify constraints and limitations of the reforms. The study will then delineate key areas where outstanding reforms need to be undertaken in order to take the liberalization process forward.
Aid Effectiveness: The Sri Lankan Experience
Rationale Sri Lanka has been one of the highest recipients of foreign aid, receiving approximately US$ 32 per capita since the 1980s. However, the twin impacts of Sri Lanka attaining the status of a middle-income economy in the late 1990s, and the general slowdown in aid commitment by donor nations are expected to impinge adversely on the country’s ability to increase its level of aid commitment. The country’s capacity to disburse and manage aid inflows efficiently is, perhaps, even a more important problem. An analysis of aid commitments per se does not give a true picture. Timely and efficient utilization of foreign aid is a yardstick that is increasingly being applied by bilateral donor agencies in determining future levels of assistance. In this regard, the declining trend of aid utilization in Sri Lanka, currently estimated at around 15 per cent, is a matter for serious concern. Poor management of aid assisted programmes—inadequate evaluation and preparation of projects—has been identified as a contributory factor in the low disbursement levels. The new literature on aid argues that the effectiveness of aid is dependent on the quality of economic policies; i.e., low inflation, small budget deficits, openness to trade, strong rule of law, competent bureaucracy. The lack of these no doubt also affects the level of aid utilization. Most evidence also suggests that aid money is fungible—aid is absorbed into the collective public fund and spent on whatever the recipient country wants to spend it on. Objectives The study aims to analyse recipient fiscal response to aid inflows in order to provide a more comprehensive understanding of the macroeconomic impact of aid. The proposed study will constitute a preliminary assessment (3-month duration) of the problems of aid effectiveness in Sri Lanka. Based on the findings of the study, literature survey and data availability, a more detailed analysis of the macroeconomic impact of aid will be undertaken to examine the issue of aid fungibility in Sri Lanka.
Fiscal Management and Pension Reform
Rationale Persistent fiscal deficits continue to be a fundamental problem that constrains economic growth in Sri Lanka. High recurrent expenditures on debt service payments, public sector wages and pensions, and defence expenditures are the main reasons behind the persistently high fiscal deficits in recent years. In the absence of a settlement to the civil unrest in the country, there is little likelihood of seeing an immediate diversion of resources away from defence, while interest payments on debt also remain an imperative obligation. Pension payments—accounting for 8.5 per cent of total current expenditure in 2000—is an item that requires rationalisation if public finances are to be restructured with a view to curtailing fiscal overspending. Objectives With the expected rapid demographic transition taking place in the country, the need to reform Sri Lanka’s income security arrangements in order to lessen the burden on government fiscal operations has taken on a new urgency. Several issues have risen in the current international debate on income security arrangements—on methods of funding, benefit calculations, and management— which calls for a reassessment of available options and alternatives, and their fiscal implications. While IPS has already begun work in this area, a more detailed study has to be undertaken to review the existing formal systems of retirement savings schemes, assess the fiscal implications of alternative funding schemes, and ascertain the policy options available to the country.
Monetary Policy Management
Rationale The adoption of a free floating exchange rate regime in January 2001 raises new and complex policy issues for monetary policy management in Sri Lanka. One the one hand, it provides an opportunity to set monetary policy through a more-or-less formal process of inflation targeting, and commit monetary authorities to price stability as the primary goal of monetary policy. However, inflation targeting itself raises a whole host of issues with regard to capital market liberalization, stock market regulation, the role for an independent central bank, etc. It also highlights the need for coordinated macroeconomic management of monetary and fiscal policy stances. If a government continues to run large fiscal deficits, especially where deficits have often been monetized, it will, in the long run, lead to a collapse of an inflation targeting regime. This implies that an institutional framework to keep fiscal policy in check is critical to the success of an inflation targeting strategy. Objectives
It is anticipated that the role and conduct of monetary and exchange rate policy in an evolving situation will be a continuing area of research in the Macroeconomic Policy Unit of IPS. Specific policy issues will be researched in accordance with the priority attached to examining such issues. At first, the unit’s main research focus will be to examine the determinants of inflation in Sri Lanka. While Sri Lanka has been successful in bringing down its rate of inflation in more recent years—mostly in line with a global trend that was fuelled by contracting commodity prices—more recent indicators suggest that inflation is, once again, on the rise. The purpose of this study is to ultimately identify the factors—monetary expansion, changes in costs, relative prices, aggregate demand, etc.—which best explain the movement of the aggregate price level in Sri Lanka.
Developing the Capital Market: Issues and Constraints
Rationale Following the findings and recommendations of the Presidential Commission on Finance and Banking in 1991/92, Sri Lanka implemented significant reforms aimed at developing the country’s financial sector. The reforms included improved financial disclosure requirements, re-capitalisation of the two state owned commercial banks, regulatory as well as infrastructure improvements of the Colombo Stock Exchange, etc. However, the results have been rather modest, and the financial system remains relatively shallow. The financial sector also remains inefficient as evidenced by high intermediation costs. This is partly a reflection of the high spreads of the two state owned commercial banks due to the underdeveloped nature of the capital market. Sri Lanka’s capital market remains underdeveloped despite efforts to modernize the stock exchange facilities, and promote foreign participation. In fact, since the mid 1990s, there has also been a continuous net outflow of foreign capital participation in the Colombo Stock Exchange. Market capitalization in Sri Lanka is approximately 15 per cent in contrast to an estimate of over 35 per cent in neighbouring India. Objectives Reforms aimed at strengthening the financial sector, and in turn invigorating the capital market in the country, have been long debated with little visible signs of implementation. One of the key recommendations to rejuvenate the capital market is to allow institutional investment participation by freeing investment restrictions on captured funds for government debt financing. Nearly 80 per cent of the Employees’ Provident Fund (with nearly US$ 2.3 billion in assets) investment portfolio remains in Rupee loans, a form of private placement government debt. It is proposed that IPS initiates a study to examine the implications of attempting to invest such assets in the equity market, and the wider implications of developing the bond markets in the country.
|
|
