Sri Lanka adopts strategies to maintain industry and real estate competitiveness

Industry in Sri Lanka has developed over the years by taking the high road. In part driven by necessity, the country has tended to avoid low-margin, high-volume production in favour of value addition and customisation. The result has been solid demand for its goods and a strong international reputation.

Meanwhile, investment in infrastructure has improved the operating environment, reforms are ongoing and efforts are being made to foster innovation and promote exports (see analysis). However, a number of challenges remain. International pressures, especially following the $1.5bn IMF bailout given to Sri Lanka in 2016, are compelling the state to raise tax revenues. Some rates will be increased and certain incentive structures are being adjusted. However, the operating environment, despite improvements, remains complex and several necessary reforms might be difficult to achieve. Sri Lanka’s edge in global markets is also becoming less pronounced as other countries catch up in terms of standards, practices and productivity.

Current Forecasts 

The government of former president Mahinda Rajapaksa, which lasted for a decade through 2015, was relatively statist in nature and favoured government control in key sectors. Today, the country is generally considered open and relatively liberal, and the current government is regarded as reformist. But Sri Lanka can be a difficult place to do business. In the World Bank’s “Doing Business 2018” report, the country ranked 111th overall, compared to 110th in 2017. In the starting a business category, its rank was down slightly from 77th in 2018 to 74th; in terms of enforcing contracts, it ranked 165th, compared to 163rd in 2017; and 158th for paying taxes, which remained unchanged from the previous year.

Sri Lanka has plans to improve the environment for industry and is especially targeting foreign investment. Its goal is to achieve an overall ranking of 70 in the “Doing Business” report by 2020 and become an economic hub for the Indian Ocean region. Its efforts are both incremental and transformational: taxes will be simplified, government support will be offered and international standards will be increasingly adopted. Sri Lanka also aims to develop strategies to better integrate the economy into global value chains. Zerosum, strictly export-oriented initiatives are being replaced with more openness and the pursuit of capacity that better fits with international sourcing requirements, while outside pressure is accelerating the pace of change. Following the 2016 IMF bailout, the government said it would speed up privatisation, with conditions being pushed for the state to balance the budget, make the economy more efficient and reduce government ownership in industry.

Strong to Mixed

In terms of total output, the largest industrial sector by a considerable margin is food and beverages, at 28.8%, followed by construction at 28.2% of industrial output, textiles and apparel at 14.5%, and mining and quarrying at 5.3%.

The services sector is 1.38 times the size of the industrial sector. As of the third quarter of 2017, 46.6% of the workforce is employed by services, industry employs 29.1% and agriculture 24.3%, according to the Central Bank of Sri Lanka. Overall performance has been steady in recent years despite economic headwinds and a significant political transition. In 2016 the country’s industrial sector grew 6.7%, up from 2.1% in 2015 and 4.7% in 2014. Services grew 4.2% in 2016, 5.7% in 2015 and 4.8% in 2014. At a micro-level, however, performance has been volatile, with double-digit negative declines in industrial production recorded in the first two months of 2017, and very few positive indications since the 2015 general election.

The index of industrial production (IIP) was at 103.0 in the second quarter of 2017, with the base set at 100 in 2015. Manufacturing was at 105.5. The sectors with the highest index values were clothing apparel at 108.9; basic metals, 113.8; other metals, 110.7; machinery, 109.7; rubber and plastic products, 107.1; and the lowest was the chemicals category at 82.7. Industrial production in manufacturing specifically was up 1.4% in the second quarter of 2017 compared to the same period the previous year. In June 2017 industrial production was up 0.3% over the same month a year earlier. Sectors performing particularly well over that period include basic pharmaceutical products, up 19.5%; basic metal products, up 14%; fabricated metal products, 12.7%; and food products, up 2.3%. However, the chemical products and beverage manufacturing segments were down 12.1% and 9.2%, respectively.

In August 2017 Sri Lanka’s Purchasing Managers’ Index (PMI), maintained by the central bank, was 54.4, up from 54.3 a month earlier and 53.5 a year earlier, with a value over 50 indicating growth. The positive figures were in large part due to an increase in stocks in preparation for future orders. For the services sector, the PMI was 60.1 in August, up from 59.1 the previous month, and down from 60.2 a year earlier, with particularly strong performance from financial and telecommunications companies.

Foreign Investment 

The mixed record in terms of output is largely the result of weak foreign investment and low levels of local manufacturing. Rather than focusing on attracting foreign capital and building an industrial base, the country has instead historically relied more on foreign borrowing and consumer spending. This has left it with less manufacturing than would otherwise be expected for an economy of its size.

Annual foreign direct investment (FDI) levels since 1998 have remained under 2% of GDP. At the end of 2015 FDI as a percentage of GDP was down to 0.84%, before rising to 1.1% the following year, according to figures from the World Bank. Sri Lanka is in a difficult position strategically. Labour shortages are becoming a serious challenge in Sri Lanka, negatively impacting local industry. An estimated 10% of Sri Lankans are employed overseas, and many potentially productive industrial workers are lost to construction projects in the Gulf. “Sectors that are driven mainly by manpower are currently facing challenges when it comes to recruiting and retention. Sri Lankans tend to prefer white collar to blue collar careers,” Vipul Hettige, group managing director and CEO of Certis Lanka Group, told OBG. “To change this mindset, there is a need to implement better salary structures and career plans, and to educate people on the importance of blue collar jobs in society.” In addition, efforts are being made to stem the flow of workers overseas, with the state raising overseas minimum wage requirements for Sri Lankan citizens wishing to take jobs in foreign countries to at least $400 per month in early 2017, according to the then-minister of finance Ravi Karunanayake.

Garments Without Guilt 

Sri Lanka has implemented policies and followed industry practices considered relatively enlightened among Asian manufacturing countries. Its Garments Without Guilt programme calls for human-rights compliant and environmentally friendly manufacturing that adheres to broad ethical guidelines, offering a fair wage and good working conditions and employing a skilled and educated workforce. Around 64% of the country’s garment factories are certified under the programme, or approximately 20% of the total industrial workforce, however, in garment manufacturing alone this still leaves approximately one-third of sector workers not covered by the programme guidelines, meaning many are still susceptible to lower wages and substandard working conditions.

The higher standards have helped the sector: rather than relying on the churning out of large quantities of low-margin items, Sri Lanka has targeted the higher end of the market. “We go up the value chain,” Ranil Pathirana, finance director at Colombo-based clothing manufacturer Hirdaramani Group, told OBG. “We cannot compete on the basic stuff”.

Specialisation and refinement are also apparent in other sectors. Sri Lankan manufacturers are often willing and able to customise orders in ways that their counterparts in larger economies may struggle to justify. Tyre manufacturer CEAT Kelani Holdings, for example, undertakes original equipment manufacturer work even for smaller buyers, such as a car dealer in the Philippines, and can mix and match different types of tyres in a single container, something a larger competitor might not do. Manufacturers in Sri Lanka tend to be opportunistic, gaining less by the pursuit of simple volume and more by picking up business where advantages may exist. CEAT, for example, has a strong market in southern India. This is largely because many shipping containers return from Sri Lanka to India relatively empty, due to the trade imbalance between the two economies. Transportation costs are thus negligible. For some wholesalers, it is cheaper to buy from Sri Lanka than from other parts of India because of the logistics.

In addition, Sri Lanka can also potentially build on some of the distinctive features of its garment sector in relation to exports, after the EU restored the country to its Generalised System of Preferences Plus (GSP+) programme. Tariffs for the export of clothing to the EU were thus removed completely in May 2017. Duties for approximately 6000 other products were also removed. The country was downgraded from GSP+ to standard GSP status in 2010 due to alleged human rights violations towards the end of the civil war, meaning garment exports to the EU were subject to a duty of 9.6%.

Closing the Gap

Nevertheless, industry is continually under pressure, and advantages once pronounced are becoming less so. Competition remains intense from larger countries due to the economies of scale not possible in Sri Lanka. At the same time, rivals once noted mainly for razor-thin margins and high volumes are now upping their game with regard to quality, ethical practices and customisation.

Wages in Sri Lanka remain some of the lowest in the world despite efforts to maintain ethical employment practices. In a 2015 International Labour Organisation report, wages in the Sri Lankan garment sector were found to be less than those of its peers and competitors. The monthly rate was an estimated $66-80, compared with $68-167 per month in Bangladesh, $100-145 in Vietnam and $78-165 in India. In 2015 the government set a minimum wage of LKR10,000 ($65.30) a month for all workers, but as the exchange rate fell, wages remained unchanged in dollar terms.

In terms of industry performance, however, the World Economic Forum’s 2018 “Readiness for the Future of Production Report”, ranks Sri Lanka ahead of most of its regional neighbours according to two main categories. In the first, structure of production, which relates to a country’s current manufacturing performance, Sri Lanka ranks 66th globally, ahead of Pakistan in 74th place and Bangladesh, 80th, although behind Vietnam in 48th position. Similarly, on drivers of production, which measures a country’s readiness to adapt to the changing nature of production, including new technologies, Sri Lanka ranks in 74th place, ahead of Bangladesh in 89th position and Pakistan in 93rd, and behind Vietnam in 53rd place. While the country’s industry performance remains ahead of some of its regional competitors, compared to other countries in its overall performance category it is somewhat behind. This could represent potential issues for Sri Lanka in terms of future industry competitiveness.

Meanwhile, Bangladesh and Vietnam have been gaining global market share. According to the World Trade Organisation’s 2017 “World Trade Statistical Review” Bangladesh produced 6.4% of world garment exports in 2016, up 0.5 percentage points from the end of the previous year, and 4.8% in 2012, with the second highest share next to China. By comparison, Sri Lanka exported 1.2% of the world’s total in 2016. In the first eight months of 2017, apparel exports were down 1.96% year-on-year. “We have a high volume of work at the moment, but margins are narrow,” Pathirana told OBG.

Several initiatives are under discussion to upgrade the sector, including the establishment of textile clusters and the movement of garment manufacturing to less developed areas of the country to take advantage of lower wages. It has been suggested that the minimum wage is lowered in rural and remote regions, while the sector has requested an exemption from the 2% nation-building tax and the port and airport development tax, which amounts to 7.5% of the value of imported machinery. Tax rebates on inputs sourced locally as well as subsidies to promote efficiency are also possible initiatives being considered.

Taking on Taxes 

It is not only in the garment sector that tax laws are under review. Elsewhere in industry a significant overhaul is being implemented in an attempt to improve the overall business environment. Clarity, consistency and simplicity are the aims, according to public comments by Karunanayake, then-minister of finance, in 2016. With these goals in mind, the new Inland Revenue Act was passed in September 2017, and will be effective from April 1, 2018.

Under the act, exemptions are limited and the rate schedule simplified. The number of income categories is reduced, from 10 to four, and a capital gains tax added. Certain exemptions on profits on employment have ended, the withholding tax on bank deposits doubled, and a partnership tax ended. Furthermore, income classifications for corporations have changed and tax rates have been simplified so that small and medium-sized enterprises (SMEs), exporters and other favoured sectors will all pay a similar reduced rate. While more straightforward regulations would be attractive to foreign investors, the adjustment of rates and the ending of incentives could increase costs for a number of manufacturers. Sri Lanka’s tax rates were previously low in relation to its peers – India, Bangladesh, Vietnam and Malaysia – but manufacturers are concerned that any changes to incentives could amend their cost structure. The spice industry has noted that the new Inland Revenue Act increases the effective rate paid by its SME exporters from 14% to 28%. The industry is also questioning the increase in the Economic Service Charge, from 0.25% to 0.50% of turnover, and is asking for a reduction in red tape. It hopes to sell $1.5bn of products overseas by 2020, an increase from the estimated $400m in 2017. There are also concerns about the frequency of policy changes. Companies have a difficult time making investment plans if the government changes regulations too frequently. One example is the adjustment of the loan-to-value ratio for commercial vehicle financing, which was increased to 90% from 70% at the beginning of 2017. For some manufacturers, such moves can have significant impacts on their business. In the current political environment, everything is up for discussion and industry is thus cautious. “There is uncertainty as policy discussions have still not settled down from last year,” Ravi Dadlani, the managing director and CEO of CEAT Kelani Holdings, told OBG. “In a small market, policy has a significant impact.”

Sri Lanka is aiming for $1.5bn of FDI in 2017, almost double the level reached in 2016, and $5bn by 2020. In pursuit of these goals the country is seeking more trade agreements and multilateral partnerships, working to better integrate with global value chains, opening export processing zones, and is in the process of developing a national export strategy. The government has also passed a National Trade Policy and is establishing a trade facilitation platform, the National Single Window.

Raising the Bar 

Meeting international standards is another key element of the country’s efforts. Sri Lanka is establishing a food testing and safety centre that will focus on products from villages. It will be known as the Centre for Food Analysis and Food Safety and be under the Industrial Development Board of the Ministry of Industry and Commerce. Total investment in establishing the centre is estimated at LKR140m ($914,130), and local and global standards, such as those of ISO, will be followed. SMEs in food processing employ around 1.5m people and it is an area of growth potential, with food exports more than doubling in 2016.

Such developments in the food and beverage segment could be beneficial, especially given the fact that certain markets are particularly hard to enter. “Entering the alcoholic beverage market here is quite challenging,” Suresh Shah, CEO of Sri Lanka’s Lion Brewery, told OBG. “First, there are some very strong and well-established local brands that have gained the trust of consumers over the years. Second, local producers have an advantage over regional competition because of very high import taxes, and third, alcohol marketing is prohibited, so establishing a new brand without being able to use any marketing channels is not an easy task.”

Garments also remain a focus for the government, with investments in the segment ongoing. A centre was established for the training of 35 young people by the Security Force Headquarters in Mullaittivu to introduce garment manufacturing. The initiative is known as Global Design Tex, and will employ 300 people.

Outlook 

Despite the challenges faced by industry in Sri Lanka, steady growth is expected. The country’s geographic location and market structure will continue to allow it to pursue niche, higher-end and opportunistic business opportunities. Sri Lanka will face intense international competition, but if the state can formulate policies that establish a more enabling business environment, growth will remain steady and sustainable.