Fiscal reform and trade deals drive economic growth in Sri Lanka

After years of internal conflict, Sri Lanka is enacting political and economic reforms to exert its renewed influence in the region and become an independent, global player. Time will tell if the authorities will be able to implement challenging reforms and position the nation on the international stage.

History

Sri Lanka’s first inhabitants were hunter-gatherers who likely crossed a land bridge from India and formed the first definitive settlement around 28,000 BCE. The land bridge, which disappeared by approximately 5000 BCE, allowed humans and their ancestors to easily come and go, with early Stone Age tools found on the island dating as far back as 125,000 years. By 900 BCE megalithic culture, and both the Indo-Aryan and Dravidian languages began to emerge in proximity to India, while Anuradhapura, an ancient city in the island’s interior, began to bud as a population centre.

Buddhism came from India in the 3rd century BCE, which is considered the origin of Sinhalese culture. Buddhist scholars of the era recorded much of the early history of Sri Lanka, with politics and religion intertwining throughout the island’s history. When the Tooth Relic of Buddha arrived in Anuradhapura in 371 CE, the city was one of the largest in South Asia.

The Anuradhapura Kingdom frequently fought with other dynasties on the island in a series of power struggles – including kingdoms in South India – and the ancient city of Anuradhapura was later left for a location in Polonnaruwa, which survived for two centuries. Following its abandonment, Sinhalese culture shifted south, founding the major dynasties of Kandy and Kotte, while Tamil kingdoms, notably Jaffna, grew in the north. By the 13th century a vast jungle interior and the spread of malaria to the country’s dry zone forced a separation that would divide the country through to its civil war in 1983.

While Arab traders had been present in Sri Lanka before the 7th century CE, the Portuguese arrival in 1505 – on the trail of an increasingly lucrative spice trade – brought a significant shift in Sri Lanka’s affairs. With the demise of the Jaffna and Kotte kingdoms at the hands of the Portuguese, the Kingdom of Kandy served as the central resistance and protector of the Buddhist faith for three centuries.

In 1602 the Dutch arrived, ousting the Portuguese by 1658 and obtaining a monopoly on the island’s spice trade from Kandy in exchange for notional Sri Lankan autonomy. The Dutch remained in power for 140 years until 1796, when they ceded control to England. In 1802 Ceylon became an official colony, and by 1815 the British had conquered Kandy, abolishing the monarchy in the process. This was the first time in history that the entire island was dominated by a single foreign power.

By the 1830s, drawn to the island by plantation land, settlers were arriving and often imported Indian-born Tamil plantation labour to grow crops of coconut, coffee and rubber. In the 1870s the island’s entire coffee crop was destroyed by fungus, forcing a shift to tea, which continues to be the country’s most important export crop.

Independence

While Ceylonese participation in government began at a relatively early stage, it was not until the beginning of the 20th century that Buddhist and Hindu populations began to call for greater representation in government. Constitutional changes in the 1920s and 1930s allowed more Sinhalese power-sharing and full universal suffrage. Sri Lanka became self-governed in 1946, followed by full independence on February 4, 1948 – six months after India achieved the same.

A new constitution in 1972 effectively made Sri Lanka a republic, and changed the country’s name from its former title of Ceylon. In 1978 an executive presidency was established under a revised constitution. Following this, increased spending on welfare brought improvements in heath care and education, indicators which remain high to this day. However, a wave of nationalist policy-making contributed to an overall slowdown of the economy, which had lasting implications. Sri Lanka lost a substantial portion of its tea market in the UK, while large swathes of its Burgher population migrated to Australia.

Under British rule, Tamils were favoured for government jobs and university postings, and they quickly became more proficient English speakers, causing resentment from the Sinhalese population. The rise of nationalist politics under successive administrations played on the fear that Sinhalese religion, language and culture could be overshadowed by Indians and Sri Lankan Tamils, who shared certain aspects of cultural identity. A Sinhala-only bill overtly disenfranchised the Hindu and Muslim minority populations, while making Sinhalese the official language of the country.

The conservative United National Party and more liberal Sri Lanka Freedom Party (SLFP) have been at the forefront of politics since independence. However, the Sri Lanka Podujana Permuna secured a resounding victory in the local government elections of February 2018, positioning itself as a pivotal force in the next national elections, scheduled for 2020. Each party in power has, at times, arranged coalitions with smaller parties, the strongest of which is the SLFP-led United People’s Freedom Alliance. The Buddhist clergy and labour unions maintain heavy influence in political dialogue and decision-making.

Federal Composition

The executive branch of government consists of a president, who functions as both chief of state and head of government; a prime minister, who is appointed by the president; and a Cabinet appointed by the president in consultation with the prime minister.

The legislative branch is a unicameral Parliament of 225 seats serving six-year terms; 196 are elected into multi-seat constituencies and 29 seats are allocated to different political parties, proportional to their share of the national vote.

The Supreme Court of the Republic is the highest-ranking court representing the judicial branch. It consists of a chief justice appointed by the president and no fewer than six and no more than 10 other justices, also appointed by the president with the advice and consent of the Constitutional Council. Below it sits a court of appeals, various high courts, municipal courts and primary courts, along with a number of tribunals. There are 54 judicial districts in Sri Lanka. Its legal system is a mixture, influenced by Roman-Dutch civil law as well as customary indigenous laws, including Kandyan Law and Theswalamai Law, which apply primarily to personal affairs.

Lower Governments

The country is further divided into second-tier provincial councils and third-tier local governments. While the Ministry of Local Government and Provincial Councils is responsible for national policy-making, the provincial and local authorities are responsible for implementation.

The 13th constitutional amendment – the Provincial Councils Act of 1987 – legislates this political devolution to nine provincial councils, further broken down into 25 districts and 329 divisional secretariats. Responsibilities include law and order, economic planning, education, housing, agriculture, land use and cooperative development. The supervision of local government is broken down into provincial councils. Each provincial governor, appointed by the president to a five-year term, executes policies through a board of ministers.

Foreign Relations

Sri Lanka’s strategic geographic location at the centre of significant global shipping routes remains a point of interest for nations such as China, the US and members of the EU. Indeed, the relative location of Sri Lanka should provide it with considerable foreign relations leverage, but in spite of this, the country remains bogged down by a relatively heavy debt burden and ongoing domestic political gridlock.

In 2015 the election of President Maithripala Sirisena – a moderate candidate and the minister of health under the previous administration – surprised many and was seen as a direct rebuke of former President Mahinda Rajapaksa’s perceived lack of inclusiveness. The West greeted President Sirisena as a reformer, pleased at the chance of renewed engagement with the island nation. While constitutional changes have been slow, there are signs of progress on important post-conflict reforms.

Additionally, the Cabinet has been reshuffled twice since 2015. On May 22, 2017 a Cabinet reshuffle was announced in a bid to restore confidence in the government’s handling of the economy and to give fresh momentum to recent development work. The reshuffle has affected nine Cabinet ministers and a state minister, the most significant of which was the swapping of the finance and foreign affairs ministers, Ravi Karunanayake and Mangala Samaraweera, respectively. The second reshuffle took place on February 25, 2018, when six Cabinet ministers, three state ministers and one deputy-minister were sworn in before the president. Prime Minister Ranil Wickremesinghe had been appointed as the minister of law and order but was replaced two weeks later, on March 8, 2018. GSP+: In January 2017 the European Commission recommended to the European Parliament that Sri Lanka be reinstated in the Generalised System of Preferences Plus (GSP+), a trade concession programme designed to promote economic growth in developing countries, conditional upon certain criteria, such as governance, human rights, labour conditions and environmental protection laws. After much deliberation, the EU announced the reinstatement of GSP+ benefits to Sri Lanka in mid-May 2017, enabling exporters to enjoy duty-free privileges. This is welcome news to economic and trade players, as the country has watched its neighbours and economic rivals capitalise on the GSP+ since 2010.

The affirmative outcome will also further strengthen economic cooperation. As it stands, the EU is Sri Lanka’s largest trading partner, with one-third of total exports heading to the bloc. The reinstatement of the title should immediately benefit exports, with 66% of tariff lines being removed. This applies to strategic goods such as textiles and garments, fisheries products, rubber products and machinery. Apparel manufacturers in particular would benefit, as current export revenues remain stagnant at $4.8bn, compared to Bangladesh earning $25bn in 2016 alone with full access to GSP+.

The loss of GSP+ in 2010 is said to have cost Sri Lanka $32bn in exports in the 2010-17 period, a significant sum for a nation with an interest in remaining open to the world to ensure growth. Sri Lanka is taking concrete steps in this direction with concurrent trade negotiations ongoing with strategic Asian allies. However, even with the expected reinstatement of the facility, it is not easy to recapture missed business opportunities and make up for lost time when competitor nations have gained so much ground in certain sectors.

Nevertheless, this is a vital step forward for medium- and long-term prospects. It is estimated that over the remaining 2018-19 period Sri Lanka will earn an additional $500m from potential buyers – a considerable sum that will help achieve the goal of creating greater fiscal space. The main draw of the facility is lower duties or a waiver of all export duties into the EU. This is expected to drive demand for Sri Lankan products, benefitting the greater economy, particularly through foreign direct investment (FDI).

Renewed Trade

The relationship between Sri Lanka and India could be shifting towards a more prosperous, shared future with an economic and technology cooperation agreement (ETCA) set to be ratified in 2018. Business leaders in particular see the deal as mutually beneficial. They argue that the agreement will create much-needed investment in the economy, helping to boost manufacturing and employment opportunities in struggling sectors, while also clearing the way for greater fiscal operating room so the government can bolster social safety nets and reinvest in other strategic areas. However, others argue that it provides a back door for increasing Indian control over the economy. Furthermore, China will be closely monitoring the deal, as it seeks to increase its influence.

At the World Economic Forum in Davos, Switzerland in January 2017, Prime Minister Ranil Wickremesinghe sounded upbeat about the prospect of increasing trade agreements with India and other South-east Asian neighbours. “Sri Lanka will be going in for separate trade agreements with five southern Indian states, including Tamil Nadu,” he announced at the event. “Sri Lanka will be looking at entering into a trade agreement with the ASEAN rather than going for separate trade pacts with the member states of the region. We will also have trade ties with Japan.” While some argue for the need of a more ambitious trade deal with India, the ETCA will allow for more flexibility in the exchange of services between the two governments, and this should prove to be a positive first step.

In January 2018, after 18 months of negotiations, Sri Lanka and Singapore signed a free trade agreement (FTA). The FTA seeks to drive investments from both large and smalls Singaporean companies into Sri Lanka, while also setting an example for other trading partners and potential future FTAs (see Trade & Investment chapter).

Fiscal Reforms 

Concerns raised by China and other international investors were quickly placated as the President Sirisena administration reassured them of their investments in the country. Foreign creditors, including the IMF, have shown satisfaction with reforms undertaken by the government to raise revenue and reduce debt to a sustainable level. The country’s debt-to-GDP ratio is projected to fall to 69% by the next election cycle in 2020, down substantially from a current 74%.

Contractionary fiscal policy could restrict growth over the short term as the government prepares to honour foreign debt obligations. More than one-third of public revenue is being diverted to service Chinese loan repayments, and 95% is going to foreign creditors. Consolidation lessens the balance of payments burdening the country, thus staving off a potential default, and aligns with the long-term view of expanding fiscal capacity and maintaining economic sovereignty from foreign creditors. This policy is predicted to fare better than the methods of increasing taxes and raising borrowing costs, which tend to curb investment.

As the government is expected to use reforms to increase its long-term fiscal capabilities, domestic GDP growth in 2017 has been estimated at 3.1%, with the central bank forecasting growth for 2018 to accelerate, reaching between 5% and 5.5% In addition, if Sri Lanka can import less and export more with the resumption of GSP+ trade concessions, the trade deficit would ease and the public revenue stream would diversify. As a country with one of the lowest tax-to-GDP ratios among emerging economies, building a diverse revenue stream will be vital to Sri Lanka’s future development. Moreover, the country has 245 state-owned enterprises employing approximately 1.3m people, which can prove to be a heavy burden on the balance sheet. The government could benefit from long-term solutions that reorient its role in the market economy, shifting from an active player to a more passive presence in the form of a regulator.

Regional Influence

As the tide of influence undergoes rapid change in Asia, Sri Lanka has an opportunity to position itself to capitalise on its natural competitive advantages and exert its influence in the region; getting the fiscal house in order is the best way to achieve this. While Sri Lanka is the most developed market economy in South Asia, productivity efficiencies, labour costs and a lack of scale are a concern for long-term competitiveness.

Players in the region find it encouraging to see progress being made on the Port City Colombo, a prospective financial centre in South Asia heavily backed by the Chinese government. This investment comes at a time when FDI accounts for around 1% of domestic GDP. However, the project has at times become a symbol of political wrangling, centred on the issue of economic sovereignty.

It is true that China has taken concrete steps to exert influence in South Asia. The establishment of the Asian Infrastructure Investment Bank is a signal that the Belt and Road Initiative – to link ancient and modern trade routes by land, rail and sea – will be the foremost network of economic activity in the region centred on strengthening ties with Beijing.

Sri Lanka is a vital centre along the maritime route of the Belt and Road Initiative, and in January 2017 the government announced a deal that granted China a 99-year lease of the Hambantota port in exchange for $1.1bn in debt relief. The debt-for-equity swap has proven controversial, with some in the country fearing a loss of state assets and economic sovereignty during a time of creeping Chinese influence. Others welcomed the decision, since many of the expensive projects constructed in the city by the previous administration have been left largely neglected. This will be a balancing act for the government, as it displays an investor-friendly environment to the outside world, while simultaneously convincing the local populace that residual benefits from the port will be felt by all.

Moreover, to the north lies India – Asia’s second-largest economic superpower – which is also looking on with interest and concern, as its own long-term policy goals are not aligned one-to-one with those of China. Sri Lanka will surely fare well by continuing on its path of rebalancing foreign investment in large capital expenditures to include a wider array of governments.

Outlook

Sri Lanka’s economy looks promising for the coming years, as major changes in the business environment have taken – and are taking – place in the short to medium term, such as FTAs with Singapore and China, the regaining of the EU GSP+, development of human capital and further liberalisation of the economy. These, together with the involvement of the government, are supporting the objective of transitioning to a middle-income, knowledge-based economy. The country is continuing to use exports as a driver of economic growth, with a call for a focus on business process outsourcing and ICT-related services given their performance in 2017. Sri Lanka remains heavily in debt and carries a low revenue base; however, with policy measures introduced by the government and the IMF, the country is on the right track to achieving fiscal consolidation, thus improving its economic outlook.