Private enterprise growth in the regions: What is slowing it down?

By Anushka Wijesinha, Research Officer – IPS

Small and medium enterprises – SMEs – are at the heart of any economy, and Sri Lanka is no different. Despite the inherent difficulties in quantifying the relative contribution of the SME sector to national GDP or to employment owing to informality and difficulties in classification, it is widely acknowledged that the growth of the regional SME sector can greatly contribute to the growth of the overall economy.

The Western Province contributes over 45% of Sri Lanka’s GDP. Since 2003, however, a few regions have gradually increased their GDP shares, particularly the Southern, North Western and Central Provinces. Policies under the ‘Mahinda Chinthanaya’ place a heavy emphasis on taking development to regions outside the Western Province. An array of schemes promoting regional enterprise growth have been rolled out, like the ‘Gamata Karmantha’ programme and the BOI-administered ‘Nipayum Sri Lanka’ 300 enterprises programme with generous fiscal incentives. This has been coupled with continuing improvements to regional infrastructure. Yet, besides private traders, larger private enterprises and industries in many regions have been slow to grow to any considerable magnitude. No doubt, the North-East conflict and resultant uncertainty was an overhanging factor, but in this post let us focus on some other key business constraints that may better explain this situation.

What impacts private sector growth?

A shopping list of ‘enterprise enablers’ which determine the strength of private participation in any economy can be easily listed – political and economic certainty; stable macroeconomic conditions; good infrastructure facilities like roads, electricity, and commercial water; land availability and secure property rights; access to, and affordable cost of, finance; private sector friendly policies and regulatory systems at national and local government level; access to technology; access to markets and market information; and access to suitably skilled workforce, middle management.

Focussing specifically on Sri Lanka, two key studies, one by the World Bank and the other by the Asia Foundation, have highlighted some key reasons why the regional business climate is not conducive to faster private sector growth.

Rural Investment Climate

The World Bank’s Sri Lanka Rural and Urban Investment Climate Assessment (2005) was the first comprehensive study to look at the rural investment scenario separately. It highlighted severe constraints in areas like telecoms, electricity, finance and logistics. Of course, some indicators like telecoms and electricity have visibly improved since this study. However, many of the other investment climate issues still remain relevant. Cost and access to finance was cited as the greatest constraint. Many regional enterprises have difficulty in exhibiting the requisite collateral, and regional branches of mainstream banks are very hawkish in managing their lending portfolio. This is compounded by the lack of knowledge and skills among regional entrepreneurs in developing feasible business plans acceptable to local banks. The hawkish outlook in lending to regional SMEs may ease following the recent downward revision of bank lending rates (but will no doubt be limited by the inevitable decline in long-term deposits), and also with new concessionary SME lending schemes by state development banks.

Enabling local government environment

A newer study by the Asia Foundation, the Sri Lanka Economic Governance Index, focussed specifically on local government factors affecting private enterprise growth in the regions. The findings of the study are drawn from real discussions (via focus group meetings) with the local biz sector on constraints in dealing with local government. The latest segment of the report paid particular attention to the Eastern Province and some of the key findings highlighted were:

• High unofficial ‘fees’ and charges by public officials when obtaining permits, licenses, registrations, etc
• Lack of motivation and business-friendly attitude
• Lack of information and knowledge on core activities (business registration, laws and regulation)
• Opaque and cumbersome procedures for business registration and licensing/permits
Interestingly, however, the Batticaloa MC returned the most favourable indicators out of the local authorities reviewed, coming out on top in terms of being private-sector friendly. The reasons for this ought to be studied more closely, and their best practices need to be shared among other local authorities endeavouring to reform.
Private enterprises also complain that the current multi-tiered governance structure has at times created an inconvenient ‘layer of fat’, leading to more rent-seeking and corruption. They contend that although many subjects are devolved to the local authorities, more often than not, the local authorities tend to refer the matters back to central government authorities, due to lack of expertise and clarity of authority, and to avoid any reproach. Local government authorities need to urgently adopt a more business friendly approach, discharging their duties so as it promotes private enterprise, not stymies it.

Taxation issues

Businesses in the region face several issues in taxation which are not always of the same nature as those faced by bigger corporates and manufacturers in the Western Province. Owing to their smaller scale and lower level of sophistication, regional businesses find it even harder to cope with frequent ad-hoc changes in tax rates and types. This is compounded by their limited knowledge of, and access to, the latest accounting software and IT skills which make returns preparation easier. Overall, their weaker knowledge on tax administration procedures, opening and maintaining tax files, calculation of liabilities, etc. make compliance harder and thus, less forthcoming. Naturally, this has significant revenue implications to the exchequer.

Internal reasons for lacklustre SME growth

Following years of aid flowing in to promote various SME-sector projects, complacency and a hand-out mentality have now characterised much of the sector. There is little risk taking by regional entrepreneurs and their entrepreneurial spirit is weak.

Regional businesses have also noticed a decline in the availability of regular labour, as workers tend prefers to take up state sector jobs now abundantly on offer, as well as construction sector jobs in the many infrastructure development projects. This has been especially evident in the Southern and Eastern Provinces. At higher skill levels, too, workers are scarce. The lack of middle management capacity, the limited technical business skills, including business English, are cited as serious constraints, particularly by regional SMEs that are now looking to expand and take their businesses to the next level.
These constraints not only inhibit the growth of SMEs from within the region, but also discourage outside businesses, especially those in the Western Province, from expanding to the regions.
SMEs seem averse to new development projects
From discussions with the private sector in areas where large development projects are now taking place, a common sentiment among them is fear. The local enterprise and industrial sector is fearful of, and averse to, these projects. Their perception is that they may be ‘pushed out’ of local economy, overtaken by enterprises entering from outside the area. They further complain of a lack of land availability and labour. Enterprises in Hambantota and Trincomalee have been particularly concerned in this regard.
However what they must realise is that amidst this lied great opportunity. The key is to figure out how to cleverly align themselves with new developments, piggy-back on this growth, and take advantage of the various business opportunities opening up. Feeling ‘crowded out’ and being mere bystanders will only be a self-fulfilling prophesy. However, the government too has a role to play. To truly make this new growth inclusive, the government must strive to engage the local private sector and guide it in finding lucrative ‘piggy-backing’ opportunities.
What about ‘big business’ moving to the regions?
Yes, some success stories….
Successive export-promotion strategies after economic liberalisation have built successful industries in apparels, primary products, agri-business and food processing, and various industries in EPZs. The recent USAID-CORE projects in the East and North Eastern Provinces are also encouraging which have catalysed set ups by Brandix, Hayleys, CIC, JKH and the Daya Group
…but most are still taking a ‘wait and see’ approach
Local demand as well as business confidence in the regions is still moderate and much of the large private business sub-sector is waiting for regional markets to expand. Access to land and information on availability of land is listed as a serious constraint. The policy of preventing the use of unutilised paddy land for other purposes requires rethinking.
Potential investors are now looking at ongoing projects to get a temperature check on how they fared and what their experiences have been – the feedback isn’t always good. CIC, for example, noted that heavy bureaucratic burdens meant that it took nearly 3 years to obtain some basic approvals, counting nearly 20 successive steps. Hayleys Agro, which operates under an out-grower model with Eastern farmers, noted that at times local commitment is a challenge as forward contracts have been breached by local farmers. Education of local communities is essential to meet these challenges. They need to be sensitised to the entry of the large formal private sector into their regions and made aware on how to form successful partnerships instead of perceiving it as a threat.
An example from dairy industry has also brought to the fore the issue of policy inconsistency, which further gives negative signals entrenches the ‘wait and see’ attitude. The government is currently promoting the growth of the dairy industry, but it is learnt that plans are underway to bring in legislation to prohibit the slaughter of cattle and sale of beef. Dairy industrialists are very concerned as culling of unproductive livestock is a main element of their production process.
Moving forward
The key question remains, in the short to medium term, will investments come from big businesses in the Western Province and abroad, or will it be mainly from sources within the regions themselves?
Due to years of slow growth, regional enterprises do not have sufficient ploughed back capital available to expand into larger operations, especially in post-conflict areas and lagging regions. Meanwhile, the numerous ‘investment inconveniences’ highlighted throughout this article indicate that ‘big business’ from the Western Province, or even from foreign countries, may not be willing to rush into regional investments either.
A middle ground appears more feasible, where regional entrepreneurs form partnerships and joint ventures with counterparts in the ‘big business’ arena. For this, though, regional businesses must become attractive partners. They need to show their entrepreneurial spirit, and become risk takers, moving away from a hand-out mentality. They need to develop good business plans, accounting standards and honest business practices, whilst improving their management capabilities and IT skills.
NEDA to give leadership, regional chambers to be sherpas and megaphones
The recently revitalised National Enterprise Development Authority (NEDA) would be a useful vehicle to address some of these issues, particularly through the forthcoming National Enterprise Development Policy; for which the input of regional entrepreneurs and regional chambers will be vital. NEDA was established to carry forward the work begun in 2002 to develop a ‘National strategy on SME development’, for which the IPS prepared the white paper for the GoSL. However, this initiative more funds and donor support will be key to take it to the next level. Ideally, NEDA should be to SMEs what BOI is to large enterprises – a ‘one stop shop’.
Regional chambers of commerce have a strong role to play in catalysing these efforts. They need to be sherpas, to guide enterprises looking to capitalise on spill-over opportunities from new development projects. They also need to be megaphones, to sound off to the government on the need to engage with them and also be stronger advocates lobbying to improve key business constraints. The next post will take a quick look at how regional chambers can become potent focal points for private enterprise in the regions.