Sri Lanka's new trade agreements to kick-start fiscal reform

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. As political tensions continue following the constitutional crisis in 2018, it remains to be seen whether the authorities will be able to implement its programme of 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 is thought to have disappeared by 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, started to expand 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 formation. When the Sacred 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 – including kingdoms in South India – on the island in a series of power struggles, and the 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 Empire, the Kingdom of Kandy served as the central resistance and protector of the Buddhist religion for three centuries.

In 1602 the Dutch arrived, ousting the Portuguese by 1658 and obtaining a monopoly over 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 most important export crop.

Independence & Politics

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 an increase in representation in government. Constitutional changes in the 1920s and 1930s allowed greater Sinhalese power-sharing, in addition to 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 made the country a republic and changed its former title of Ceylon to the Democratic Socialist Republic of Sri Lanka. In 1978 an executive presidency was established under a revised constitution. Following this, increased spending on welfare brought improvements in health 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 among 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, which were initially scheduled for 2020 but may now be pushed forward as a result of a constitutional crisis that involved the removal of the prime minister in late 2018. 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 also maintain heavy influence in political dialogue and decision-making.

Federal Composition

The executive branch of government consists of a president, who functions as both head of state and head of government; a prime minister, who is appointed by the president; and a Cabinet, which is 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 influenced by Roman-Dutch civil law and customary indigenous laws, including Kandyan Law and Thesawalamai 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 No. 42 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 including China, the US and members of the EU. Its location should provide it with considerable leverage in the arena of foreign relations; however, a relatively heavy debt burden and ongoing domestic political gridlock have cast doubts on the benefits of a relationship with Sri Lanka.

In 2015 the election of President 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. However, the constitutional crisis that erupted in late 2018 has caused concern among the international community. The Cabinet has been reshuffled four times since 2015 – most recently following the political crisis in late 2018, with President Sirisena appointing a 30-member Cabinet, including himself and the prime minister. Most ministers in place prior to the crisis returned to their previous ministerial positions along with new appointees, including Ravi Karunanayake as minister of power, energy and business development.

Generalised System of Preferences

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, including 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, with 66% of tariff lines being removed. This is welcome news to Sri Lankan stakeholders, as the country has watched its neighbours and economic competitors capitalise on the programme since 2010.

The EU is Sri Lanka’s largest trading partner, accounting for one-third of total exports. The reinstatement has already paid off, with trade exports to the EU having increased by 18% since Sri Lanka regained GSP+ preferential treatment. This applies to strategic goods such as textiles and garments, fisheries products, rubber products and machinery. Apparel manufacturers in particular are expected to benefit, as current export revenue remained stagnant at $4.8bn, compared to Bangladesh earning $25bn in 2016 alone with full access to GSP+.

The loss of GSP+ in 2010 was estimated 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 GSP+ reinstatement, it will not be easy to recapture missed business opportunities and make up for lost time when other countries have gained so much ground in certain sectors. Nevertheless, this is a vital step forward for medium- and long-term prospects. It is expected to drive demand for Sri Lankan products, benefitting the greater economy, particularly through foreign direct investment (FDI).

Trade Agreements

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 the near future. Business leaders in particular see the deal as mutually beneficial, arguing that it would 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 the agreement provides a back door for increasing Indian control over the Sri Lankan economy. Furthermore, China will be closely monitoring the deal as it also 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 trade agreements with India and other Southeast Asian neighbours. “Sri Lanka will be going in for separate trade agreements with five southern Indian states, including Tamil Nadu,” he said at the event. “Sri Lanka will be looking at entering into a trade agreement with the Association of South-East Asian Nations, 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 countries.

In January 2018, after 18 months of negotiations, Sri Lanka and Singapore signed a free trade agreement (FTA). The FTA seeks to drive investment from both large and small Singaporean companies into Sri Lanka, while also setting an example for other trading partners and potential future FTAs. However, the pact has come under scrutiny, garnering mixed reactions from the Sri Lankan business community. In early 2019 the Ministry of Development Strategies and International Trade decided to review all feasibility studies carried out for proposed FTAs with the assistance of the Department of Commerce.

Mid-July 2018 saw the start of negotiations between Sri Lanka and Thailand for an FTA, which is expected to be signed sometime in 2020.

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 70% by the next election cycle in 2019/20, down substantially from 77.6% in 2017. 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 burden, 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.

With the government expected to carry out reforms to increase its long-term fiscal capabilities, the Central Bank of Sri Lanka recorded GDP growth of 2.9% in the third quarter of 2018, which is predicted to rise to 4% in 2019. In addition, if Sri Lanka can import less and export more with the resumption of GSP+ trade concessions, it would curb the trade deficit and diversify the sources of public revenue. As a country with one of the lowest tax-toGDP ratios among emerging economies, building a diverse revenue stream is to development.

The country recorded 400 state-owned enterprises in 2017, and there were approximately 1.3m employees registered in the public sector in 2015, which can 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 its fiscal house in order is the best way to achieve this. While Sri Lanka is the most developed market economy in South Asia, productivity inefficiencies, 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 Port City Colombo, a $1.4bn prospective financial centre in South Asia backed by China (see Transport chapter). This investment came at a time when FDI accounted for around 1% of GDP.

However, the project has at times become a symbol of political wrangling, centred on the issue of economic sovereignty. Indeed, China has taken concrete steps to exert influence in South Asia. The Belt and Road Initiative – China’s ambitious project to link ancient and modern trade routes by land, rail and sea – is set to 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 fearing a loss of state assets and economic sovereignty during a time of creeping Chinese influence. Others welcomed the decision, since many of the costly projects constructed in the city by the previous administration have been 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 is expected to fare well by continuing on its path of rebalancing foreign investment and large capital expenditure to include a wider array of government revenue.

Outlook

Political tensions in the latter part of 2018 slowed the momentum of Sri Lanka’s economy, weakening gains made earlier in the year. Nevertheless, political stabilisation and advances in the export sector are expected to drive growth over the coming year. Supported by the trade advantages offered by the GSP+ programme, as well as progress in its national export strategy, Sri Lanka has reasons to be optimistic about its near-term prospects. The country is aiming to better use exports as a driver of economic growth and is working on strengthening ties with existing trade partners while setting up new ones with its neighbours.

A number of challenges persist, however. The country remains heavily in debt and has been challenged by steep currency depreciation in recent years. However, with policy measures introduced by the government under guidance from the IMF, the country is on the right track to achieving fiscal consolidation and improving its economic outlook.