Export outflows and investment inflows set to grow in Sri Lanka

Trade and investment activities in Sri Lanka benefit from the country’s location along busy Indian Ocean trade routes, access to the larger markets of India and Pakistan, abundant agricultural and industrial exports, and a young skilled workforce. Value-added textiles have joined tea, rubber and spices to become a major export earner in recent years, while foreign direct investment (FDI) inflows hit record highs in 2017. Still, both FDI and exports continue to miss government targets, and subdued export growth and rising fuel imports have pushed the trade deficit to new highs.

New Moves

With this in mind, the country is embarking on a bold reform programme that should offer substantial new support mechanisms for trade and investment. The Vision 2025 mid-term economic development strategy calls for increased private sector participation in infrastructure projects, as well as new investment in industrial and free zones to boost value-added exports. Moreover, a new trade strategy published in early 2017 targets tariff reform as a key ingredient to improving the business climate and supporting export-oriented investment.

Importantly, the Ministry of Finance (MoF) also established a dedicated public-private partnership (PPP) agency in early 2017, with the aim of facilitating new cost-sharing frameworks to construct major infrastructure. Vision 2025 aims to expand PPPs into tourism, health care and agriculture, placing an emphasis on innovation and value addition, with recent investment announcements indicating high potential in pharmaceuticals. Following decades of civil conflict, a host of bilateral and multilateral trade agreements are also set for revival, with Sri Lanka signing its first free trade agreement (FTA) in a decade in early 2018. Restoration of the Generalised System of Preferences Plus (GSP+) trade concessions with the EU, Sri Lanka’s largest bloc export market, has further brightened the 2018 outlook.

Oversight

The Ministry of Development Strategies and International Trade (MODSIT) and the Ministry of Industry and Commerce (MIC) function as the primary government bodies responsible for trade and investment growth. They collaborate to undertake promotional programmes, draw up strategies to attract FDI and private sector investment, and work to expand international market opportunities for Sri Lankan products. Operating under the MIC, the Department of Commerce (DoC) formulates foreign trade policy. It promotes bilateral, regional and multilateral trade relations under four divisions: multilateral trade affairs, bilateral trade relations, regional cooperation and trade promotion.

The Board of Investment (BoI) is responsible for overseeing new investments in the country, and is intended to act as a single window providing a one-stop service for all foreign investors regarding project approval, government incentives and utility services, as well as resident visas and import/export clearance. The US International Trade Administration (ITA) reports that while the BoI is relatively straightforward and effective in assisting investors establishing a business in export processing zones, it is less effective in supporting large investments outside of those areas, with the registration of foreign company branch offices considered expensive.

The Export Development Board (EDB) was established in 1979 and acts as the executive arm of the Export Development Council of Ministers. Led by President Maithripala Sirisena, the EDB is the apex organisation for export growth and promotion.

Another important trade and investment body is the Department of Registrar of Companies, which handles all business registration in the country. The ITA reports the process for company name approval is done in person instead of online, with the process taking seven to 10 days on average. Companies must also register with the Inland Revenue Department and Department of Labour upon establishing operations in Sri Lanka. Steps are currently being taken to improve the process by moving it online.

Ownership Limits

The ITA reports that the government of Sri Lanka allows 100% foreign investment across most commercial, trading and industrial activities, barring air transportation, coastal shipping, large-scale gemstone mining, gambling, military hardware and vehicle manufacturing, drugs and alcohol, currency, toxic chemicals and security documents. Foreign investment is also prohibited in non-bank money lending and pawn-brokering activities, small-scale retail trade with less than $1m of capital investment and coastal fishing.

Foreign investment is limited to 40% in other areas, such as the production of exported goods that are subject to international quotas; growing and primary processing of tea, rubber and coconut; timber industries; deepsea fishing; mass communications; education; freight forwarding; travel services; and businesses providing shipping services. Any ownership exceeding 40% must be approved on a caseby-case basis by the BoI, although the government is currently considering opening higher education to foreign investment (see Education chapter) and recent budget announcements indicate foreign ownership limits in the shipping industry will be reduced (see Transport & Logistics chapter).

Vision 2025

Published in September 2017, the Vision 2025 economic development agenda targets achieving upper-middle-income country status by 2020, meaning annual per capita income of at least $5000, as well as boosting annual exports to $20bn and annual FDI inflows to $5bn.

Vision 2025 dovetails with the Western Region Megapolis Master Plan (WRMMP), which was published in 2016 and seeks to transform the capital of Colombo and the Western province as a whole into an integrated, advanced supercity split into dedicated zones focused on industrial production and exports, green innovation, residential real estate, aviation, logistics and financial services (see Construction & Real Estate chapter).

In December 2016 the Ministry of Megapolis and Western Development reported that the project – which comprises 150 smaller initiatives, including Port City Colombo – could attract up to $30bn of FDI inflows over the next decade.

Reform Agenda

Achieving Vision 2025 targets will entail significant improvements to the business environment and investment climate, with the plan emphasising incentivised investment, export-oriented trade policy reforms and expansion of the services economy. It also aims to raise Sri Lanka’s ranking on the World Bank’s doing business index from 111th in 2018 to 70th.

As highlighted by the policy document, Sri Lanka’s Task Force for Investment Climate Reforms was created in July 2017 to identify the key actions necessary to improve the domestic business environment, with a focus on the World Bank indicators: ease of starting a business, dealing with construction permits, property registration, credit access, protecting minority investors, trading across borders, enforcing contracts and resolving insolvency. Vision 2025 also includes plans to launch a one-stop shop and single-window system for new business registration, which would bring more than 20 government agencies involved in starting a business together under one roof, streamlining the investment process.

Incentive Shake Up

Additional targets include phasing out tax holidays, a historic mainstay of the government’s investment incentive package, and switching to “other forms of efficiency-improving incentives”, with a revised investment framework expected to improve policy coherence and consistency. Vision 2025 further calls for a standardised incentive package with clear eligibility criteria, as well as an incentive system that is linked directly to capital investment in physical assets and infrastructure. High-tech and innovative industries are also slated to benefit from tailored incentives under Vision 2025, although those are yet to be specified.

At present, investor incentives include tax holidays ranging from four to 12 years, depending on the project’s capital investment, as well as exemptions from Customs duties, value-added tax, and the Ports and Airport Levy (PAL) for imports of capital goods, provided they are for large-scale projects of national strategic importance. A recent report by the World Bank urged Sri Lanka to reform its import tariff structure, recommending it phase out para-tariffs, including the PAL (see analysis).

Partner Projects

In addition to reforms to the investment climate, Vision 2025 focuses heavily on deploying PPPs to reduce the country’s dependence on loan agreements to finance public assets and services. This task coincides with the creation of a sizeable infrastructure development agenda detailed by the related Public Investment Programme, a plan that runs from 2017 to 2020.

After establishing a dedicated PPP department under the MoF in January 2017, the state is now working to draft a “clear PPP policy with a well-defined legal, regulatory and institutional framework to attract private players with the requisite capacities.” PPPs have already been successfully deployed in the energy sector for decades, with over $1bn of joint power plant projects reaching financial close between 1990 and 2012 (see Energy chapter). PPP development is expected to accelerate in the transportation sector, with domestic airports, new expressways and port projects all slated to be constructed or upgraded under the joint framework (see Transport & Logistics chapter).

Still, Vision 2025 emphasises expanding PPPs beyond these sectors, specifically naming health care, education, real estate and tourism as areas holding high potential for partner development. According to the 2018 budget statement in late 2017, the MoF issuing guidelines on PPPs was imminent. Plans were noted to deploy the model across sectors already named, in addition to agriculture, retail and minerals (see Economy chapter).

Investment Prospects

Although 2017 was a record year for FDI, inflows have fallen consistently short of the government’s targets. In December 2017 the MODSIT reported a strong pickup in FDI, reporting that inflows rose to hit $1.7bn in 2017, more than double that of 2016. Investment was overwhelmingly regional, with China accounting for 37% of total inflows, followed by Hong Kong at 17%, India at 10%, Malysia at 5% and Singapore at 5%. Infrastructure represented 61% of FDI, followed by manufacturing at 20% and services at 19%.

The MODSIT projected that Sri Lanka would end the year with $1.36bn of FDI inflows, but the country wound up exceeding this forecast: in January 2018 the BoI reported that BoI-approved foreign investment doubled in 2017 to hit an all-time high of $1.63bn, from $802m in 2016. However, this was still below the government’s ambitious target of $2.5bn. Infrastructure recorded the highest investment growth rate in 2017, at 190%, while services – including tourism and IT – grew by 50% and manufacturing investment grew by 27%, according to the BoI.

World Bank data shows that net FDI inflows rose from $479.7m in 2006 to $752.2m in 2008, and then dropped off to $404m in 2009 and $477.6m in 2010 before surging to a high of $955.9m in 2011. Net inflows moderated to $941.1m in 2012, $932.6m in 2013, $893.6m in 2014 and a five-year low of $679.7m in 2015, before bouncing back to $898.1m in 2016 – $96m higher than the BoI-approved figure.

FDI inflows as a percentage of GDP have followed an inconsistent pattern over the same period as well, falling from a peak of 2.85% in 1997 to 1.7% by 2006, according to the World Bank. Inflows then dropped to a 10-year low of 0.84% of GDP in 2010 before recovering to 1.46% in 2011, but decreasing again to 1.38% in 2012, 1.26% in 2013 and 1.13% in 2014. FDI dropped off to 0.84% of GDP once more in 2015, before gaining ground to 1.1% in 2016. Furthermore, Santander Trade reports that Sri Lanka’s total FDI stock has fallen in recent years, from $10.57bn in 2014 to $10.02bn in 2015 and $9.74bn in 2016, or 13.2%, 12.3% and 11.8% of GDP, respectively.

The BoI has again laid out a target of reaching $2.5bn of FDI inflows in 2018. While excessive bureaucracy, land acquisition hurdles and high import costs will continue to challenge growth, ongoing investment and trade policy reforms, including changes to the country’s complicated and inefficient tariff system, should help boost FDI inflows in the upcoming years (see analyses).

“FDI in 2017 did not meet expectations,” Eran Wickramaratne, the state minister of finance, told OBG. “I expect FDI in 2018 to register increased growth, taking into account the reinstated GSP+ status, the new budget and upcoming FTAs.”

Belt & Road Effect

Although the EU, as a regional bloc, is Sri Lanka’s largest trade partner, China stands as its largest lender and investor, with former President Mahinda Rajapaksa spearheading an infrastructure development programme financed largely through Chinese loans between 2010 and 2015. Forbes reported that $4.8bn worth of Chinese loans were allocated to Sri Lanka during his presidency. Speaking at the Belt and Road Forum for International Cooperation in May 2017, Prime Minister Ranil Wickremesinghe said Sri Lanka’s current development agenda aligns with China’s Belt and Road Initiative, a massive global infrastructure investment programme intended to revive historic trade routes between China and Europe. Sri Lanka, for its part, hopes to leverage its strategic location and connectivity to become a major trade and transport hub on Indian Ocean routes, in line with Vision 2025 and budget targets (see Economy chapter).

“Two competitive advantages were taken into consideration when drafting the 2018 budget. First, Sri Lanka has a favourable geographic location that enables the country to be a logistics centre between two huge markets, China and India,” Wickramaratne told OBG. “Second, even though Sri Lanka is small, it has a well-educated human resource base.”

According to Santander Trade, China has increasingly invested in the country in recent years, with the project pipeline valued at $6bn in mid-2016. Bigticket projects already delivered with Chinese funding or by Chinese companies include the Mattala Rajapaksa International Airport (MRIA) and Magam Ruhunupura Mahinda Rajapaksa Port (MRMRP), both in Hambantota, as well as the Lakvijaya – or Norocholai – coal power plant in Puttalam. All three have significantly underperformed since opening, however, while Sri Lanka’s debt to China had swelled to an estimated $8bn by December 2017 (see Transport & Logistics and Energy chapters).

Earlier in 2017 Sri Lanka sold a 70% stake in the $1.4bn MRMRP project to a Chinese firm on a 99-year lease, a changeover which occurred in December. According to the Financial Times, the port and a planned integrated industrial zone will benefit from up to $5bn of Chinese investment, creating 100,000 new jobs in the coming years. However, both countries have faced criticism over the deal.

Financial Servicing

The largest Chinese-backed project under development in Sri Lanka is Port City Colombo, which was suspended from March 2015 to March 2016 in the wake of ongoing protests against rising Chinese influence in the country.

The $1.4bn project aims to deliver a national and regional financial district on a 269-ha parcel of land near the Port of Colombo, over 70% of which had been reclaimed by February 2018 (see Construction & Real Estate chapter). The city is expected to draw substantial investment into Sri Lanka’s financial services sector, with developers reporting that it will attract up to $13bn of FDI in the years following 2018, creating up to 83,000 new jobs (see analysis).

A number of major deals with China leave Sri Lanka well positioned to leverage competing geopolitical interests in financing new domestic infrastructure that will link the country to other regional economies. Multiple media outlets report that rising concern regarding China’s influence over critical national assets has prompted other countries to step in and ramp up activities and investment in Sri Lanka. For example, the government of India is currently negotiating a deal to purchase a stake in MRIA, and the government of Japan recently signed a deal with Sri Lanka and India to build new liquefied natural gas import infrastructure (see Transport & Logistics and Energy chapters).

Trade Flows

Additional investment, particularly in the industrial and manufacturing sectors, will be critical in helping Sri Lanka reduce its rising trade deficit. European Commission (EC) statistics show that the value of total trade with all partners has risen substantially over the last decade, growing from €13.65bn in 2006 to €16.82bn in 2010, €23.03bn in 2011 and a 10-year high of €26.46bn in 2016. Import growth has outpaced exports, however, and Sri Lanka’s trade deficit simultaneously widened from €2.68bn in 2006 to €6.66bn in 2011. The deficit shrunk in the years that followed, ranging from €4.48bn to €6.28bn between 2012 and 2015, before jumping to a high of around €8.31bn in 2016.

Data from the DoC paints a slightly different picture, reporting that the trade deficit jumped from $4.05bn in 2010 to $9.69bn in 2011, before shrinking to $7.94bn in 2013. The deficit has risen steadily since then, hitting a five-year high of $9.3bn in 2016. While exports and imports have both grown over the years, the import bill has indeed risen faster than export earnings since 2010. According to the DoC, export value as a percentage of imports that year was 67%, which dropped to 55% in 2013 and 52% in 2016. The DoC provides another helpful metric: export value as a percentage of GDP at 2010 constant prices. This figure grew from 14.78% in 2010 to 17.94% in 2014, and came in at 16.51% in 2016.

Reporting with provisional data for 2017, the Central Bank of Sri Lanka (CBSL) shows that both exports and imports rose again that year. Exports brought in rose from $10.31bn in 2016 to $11.36bn, while imports increased from $19.18bn to $20.98bn. This gave rise to a trade deficit of $9.62bn in 2017, with export income covering 54% of the import bill.

In its November 2017 report “Sri Lanka Development Update: Creating opportunities and managing risks for sustained growth”, the World Bank recalled that Sri Lanka pioneered economic liberalisation in South Asia during the late 1970s, although a series of policy reversals rolled out since the mid-2000s has led the country to regress to the trade restrictiveness seen in the early 1970s.

The organisation reports that para-tariffs – charges levied on an imported good in addition to, or in place of, a tariff – including an import and export cess and the PAL, have created a strong anti-export bias in Sri Lanka (see analysis). This has shrunk the country’s trade-to-GDP ratio from 89% in 2000 to just 48% in 2016, with the World Bank arguing that an inward-oriented growth model has weakened Sri Lanka’s external position. This has left the country vulnerable to shocks in its key export markets and highly dependent on its two largest export markets: the EU and the US.

Trade Partners

With €4.44bn worth of total trade in 2016, the EU is the country’s largest trade partner, followed closely by China at €4.04bn and India at €3.96bn, according to the EC. The EU is also Sri Lanka’s top export market, receiving €2.8bn worth of goods in 2016, or 30.8% of all exports. The US ranks second among Sri Lanka’s export partners, purchasing 28% of goods, thus leading the US and the EU to receive over half of all exports in 2016. The value of US-bound exports stood at €2.54bn that year, followed by India in third place at €498m, the UAE at €211m and Japan at €181m.

Sri Lanka has recorded a healthy trade surplus with the EU over the previous decade, with the surplus growing from €812m in 2006 to €1.06bn in 2011 and €1.22bn in 2014, before halving to €523m in 2015. The figure rebounded, however, to record a surplus of $1.15bn in 2016, against a €3.68bn deficit with China and a €2.96bn deficit with India. Imports from China stood at €3.86bn in 2016, against €3.46bn from India. The EU, the UAE and Singapore rounded out Sri Lanka’s top-five import sources, with €1.64bn, €963m and €931m worth of goods, respectively.

According to local media in January 2018, total exports improved by 16% year-on-year in November 2017, in part due to the EC restoring GSP+ trade concessions to Sri Lanka, effective May 2017. Sri Lanka lost GSP+ preferential treatment – which includes reduced import duties across 6600 tariff categories – in August 2010 for failing to address human rights concerns. The restoration should help Sri Lanka meet its target of global apparel exports of $8bn annually by 2020 (see analysis). IMPORT/EXPORT BASE: Sri Lanka’s export base is currently dominated by textiles and agricultural products, with the CBSL reporting that textiles and garments accounted for $5.03bn of export receipts in 2017, representing 44% of the total, followed by tea at $1.59bn, rubber products at $835m, petroleum products at $434m and spices at $406m.

Intermediate goods accounted for the largest share of the import bill in 2017 at approximately $11.44bn, or some 55% of the total, of which the largest subcategory was fuel at $3.43bn. Textile and textile articles were second at $2.72bn, followed by chemical products at $835m, while both diamonds and precious or semi-precious stones, and vehicles nearly tied at roughly $772m.

Goals & Reforms

The government has targeted $13bn in exports for 2018, with the EDB reporting in January 2018 that exports could rise as high as $15bn for the year, putting Sri Lanka on track towards meeting its intermediate Vision 2025 goal of $20bn in exports annually by 2020.

In a bid to reduce the cost of doing business, boost both service and goods exports and shrink its trade deficit, the government is currently restructuring its trade strategy. Reforms are set to include reducing or eliminating para-tariffs, expanding bilateral and multilateral trade ties, and financing a series of export support programmes for small businesses and manufacturing investors.

In November 2017 the MoF announced plans to abolish para-tariffs for 1200 separate items. In addition, anti-dumping and anti-monopoly laws – which are aimed at protecting local producers from unfair trade practices – were passed in early March 2018.

Export-oriented small business support is also highlighted in recent policy developments, with the 2018 budget unveiling small and medium-sized enterprise (SME) support mechanisms, including a LKR800m ($5.22m) export market access programme and a LKR10bn ($65.3m) allocation to establish an export-import bank targeting SMEs (see Economy chapter). “The 2018 budget focuses on encouraging investment in the tradeable sector. At the moment, a few big companies account for 90% of all export earnings. Therefore, it is vital to strengthen SMEs in tradeable activities so export earnings are dispersed and the exposure risk is reduced,” Wickramaratne told OBG.

Bilateral Agreements & FTAS

Bilateral and multilateral trade ties are also being revived, with the government increasingly moving to capitalise on its strategic geographic position, competing geopolitical interests in the region and strong relationships with its much-larger neighbours as it moves to sign new FTAs. The country already benefits from long-standing FTAs with India and Pakistan, offering potential investors a springboard into larger regional markets by establishing operations in Sri Lanka.

In January 2018 Sri Lanka entered into its first FTA in a decade, signing a deal with Singapore. The agreement is significant as it is the first comprehensive trade pact the government has signed beyond goods – covering services, investment, sanitary and phytosanitary measures, technical barriers to trade, trade remedies, dispute settlement, Customs cooperation, government procurement, e-commerce and intellectual property rights. “The recently inked comprehensive FTA with Singapore, coupled with the enhancement of the existing agreement with India and those being negotiated with China and Pakistan, would facilitate business relocation to Sri Lanka and augur well for rental markets as well,” Pradeep Moraes, director of Altair, told OBG.

Looking East

The Singapore FTA is additionally important because it is part of the government’s broader push to “look east” in building new trade ties and reducing the country’s dependency on the EU and US export markets. Sri Lanka imported €931m worth of goods from Singapore in 2016, according to EC data, with exports to the country standing at just €98m. One of Singapore’s neighbours is also receiving attention as part of this new focus. During a January 2018 visit from Joko Widodo, the president of Indonesia, the government announced that the two countries will focus their attention on drawing up an FTA and encouraging bilateral investment. The government is negotiating FTAs with Bangladesh and Malaysia as well. President Sirisena met with Malaysian Prime Minister Seri Najib Tun Razak to discuss the possibility in December 2017, and a few months earlier Bangladesh and Sri Lanka’s ministers of industry met in Colombo and called on their respective governments to accelerate FTA negotiations. Local press reports that bilateral trade between Bangladesh and Sri Lanka tripled between 2010 and 2016, rising from $48m to $142m.

“There is no doubt that FDI will boost growth in Sri Lanka’s economy, and a good way to facilitate this is through FTAs,” Romesh David, CEO of South Asia Gateway Terminals at the Port of Colombo, told OBG. “The country is on the right track in this sense, considering the existing and recently signed FTAs and additional agreements that are on the horizon.”

Balancing Interests

Perhaps carrying the most significant benefits, the country is also negotiating an FTA with China after the two governments signed an Investment Promotion and Economic Technical Cooperation Agreement in April 2016. At the Belt and Road Forum for International Cooperation, hosted in Beijing in May 2017, the MODSIT announced that it hoped to enter into an FTA with China by the end of the year. However, Reuters reported in February 2018 that the Sri Lankan government wishes to have more time to weigh the impact such an agreement would have on local businesses, as many have raised concerns over growing Chinese influence.

Still, Chinese investment is expected to provide the most noteworthy support mechanism for Vision 2025’s goal of transforming Sri Lanka into a global logistics and shipping hub. Indeed, Karunasena Kodituwakku, Sri Lanka’s ambassador to China, announced at the same forum that China had agreed to provide RMB400m ($59.9m) worth of grants to Sri Lanka in 2017, and a further RMB2bn ($299.6m) of funding between 2018 and 2019.

The Asian Infrastructure Investment Bank, of which Sri Lanka is a founding member, is also expected to provide concessionary loans for infrastructure development, according to local media.

Outlook

Trade and investment are both set for robust growth in the near- and mid term, as the government continues to advance progressive reforms aimed at improving the investment climate and boosting exports. The longer-term outlook is positive as well, particularly if Sri Lanka is able to use competing geopolitical interests to its benefit, with transportation and industrial investment from China and India set to jump, and China keen to further advance its Belt and Road Initiative.

A hefty import bill and a considerable trade deficit remain causes for concern, as do relatively low levels of FDI. However, varying regional interests have left Sri Lanka well positioned to negotiate beneficial trade and investment deals, which will support the government’s large-scale infrastructure agenda and readjust the balance of import/export flows.