Raft of new trade deals set to unlock Sri Lanka's economic potential

Positioned between west and east Asia, Sri Lanka sits on major maritime route between Europe and the Far East and its natural resources have made it a trading centre for millennia. As the country’s economy has liberalised and grown in recent decades, its trade volumes to developed markets and emerging ones have risen strongly. The country has established a name for itself as a leading exporter both of manufactured goods and traditional products such as tea and spices.

A free trade agreement (FTA) with India signed in 2000 has proved a major boon and is now being followed by a raft of other deals that should both boost export potential and open markets to foreign producers and investors. Structural and political issues have held back foreign investment in Sri Lanka in the past, but with new FTAs in the pipeline, and a government committed to attracting global investors to drive economic growth, the outlook is improving.

Reforming The Past

Sri Lanka’s post-independence economic history has been shaped both by two decades of state socialism in the 1960s and 1970s and the civil war from 1983 to 2009. During the first era, the state controlled much of the economy, while in the second there were periods in which swathes of the country were off-limits to most investors, even though Colombo and several other major economic centres were able to flourish despite the conflict. Historically, the country has not attracted the international capital that its competitive advantages suggest it could. A number of factors hamper investment, including bureaucracy and red tape, limits on land and other asset ownership, and poor infrastructure.

Reforms introduced in 1977 marked a sharp departure from previous economic policies, with a new emphasis on the private sector and export-led growth replacing import-substitution policies. However, just at the stage when Japan was starting to invest across East Asia in the 1980s, the civil war broke out, meaning that Sri Lanka missed out on the regional investment boom. A second wave of reform began in 1989, with efforts to control inflation, ease foreign exchange restrictions and reform taxes. Privatisation also picked up again. This led to a growth in foreign direct investment (FDI), which slowed following the 1997-98 Asian financial crisis and intensified conflict with the militant organisation the Liberation Tigers of Tamil Eelam. Recent years have seen a substantial increase in investment thanks to robust economic growth, the peace dividend and an increasingly active government policy to attract global capital.

Exports

Export earnings rose slightly by 4.8% year-on-year (y-o-y) from LKR119.86bn ($817.3m) to LKR125.6bn ($856.3m) in October 2016, according to figures from the Central Bank of Sri Lanka (CBSL), as agriculture dropped while industrial exports increased. Lower demand and declining global prices pushed agricultural export earnings down 5.2% y-o-y to LKR29.05bn ($198.1m), with exports of tea – Sri Lanka’s second-biggest export earner after garments – falling 5.6% to LKR15.87bn ($108.2m). Several of Sri Lanka’s biggest tea export markets, including Russia and several Middle Eastern countries, have been affected by falling oil prices, while the former has been hit by deep recession and currency depreciation.

Seafood exports increased by around 14% y-o-y to LKR1.96bn ($13.4m) in October 2016, as the EU lifted a ban on Sri Lankan seafood in January 2016, which had led to a 75% drop-off in exports to Europe in 2015. Spice export earnings, including from pepper and cloves, decreased by over 18% y-o-y to LKR4.21bn ($28.7m). Following several years of decreases due to lower global prices, rubber export earnings were up by nearly 55% to LKR447.8m ($3.1m). Industrial export value grew 8.1% y-o-y to LKR96.05bn ($655m) in October 2016, as manufactured goods tend to be less susceptible to price volatility than agricultural goods. The huge textile and garment sector saw a y-o-y rise of 5.6% to LKR57.52bn ($392.2m) in October 2016.

Imports

Following a 2.5% drop in imports by value in 2015, due to lower international commodity prices and a government and CBSL policy intended to rationalise incoming trade, the overall value of imports increased by 18.7% to LKR279.96bn ($1.9bn) in October 2016, up from LKR235.93bn ($1.6bn) in the same month in 2015. Non-oil imports were boosted by 18.4% y-o-y, due to easing import tariffs on some motor vehicles, as well as the fall in the Japanese yen, reaching LKR242.69bn ($1.7bn). Fuel imports grew by 20.1% y-o-y to LKR37.27bn ($254.1m), while coal imports fell by around 40% to LKR2.14bn ($14.6m). Textiles surged by 41.2% to LKR34.14bn ($232.8m).

Imports of consumer goods fell by slightly more than 5% y-o-y to LKR31.92bn ($217.7m) in October 2016. Imports of clothing and accessories dropped by 50% y-o-y to LKR3.31bn ($22.6m). Vehicle imports rose only slightly by 0.8% to LKR9.5bn ($64.8m). Imports of a range of other consumer goods also rose strongly, including cosmetics and toiletries (45.3%), home appliances (35.4%), 13.2% household and furniture items, and medical and pharmaceutical products (9.1%). Imports of investment goods surged by nearly 59% to LKR92.34bn ($629.6m), partly due to a more than 250% increase in imports of transport equipment, which reached LKR37.97bn ($259m).

Import Composition

In October 2016 just over half of Sri Lanka’s imports were intermediate goods, at some 50.9%, with a total value of LKR1.31trn ($8.9bn), according to CBSL figures. During the same period, consumer goods imports accounted for nearly 25% of the total, at some LKR640.35bn ($4.4bn), while investment goods imports totalled LKR620.73bn ($4.2bn), contributing 24.1% of imports.

Further broken down, food and beverage accounted for 34% of all consumer good imports, followed by vehicles (28.8%), and medical supplies and pharmaceuticals (9.8%). Under the intermediate goods category, fuel accounted for nearly 28% of total imports, indicative of Sri Lanka’s relatively low refining capacity. Textiles and textile articles accounted for 23.8% of intermediate goods, as the large garment sector is partly dependent on imports for its inputs. Chemical products accounted for 9.02% of all imports in this category. Building materials accounted for 7.2% of all imports, with the need to import construction goods a factor pushing up costs in Sri Lanka. Machinery and equipment accounted for 12.04% of imports overall.

Trading Partners

Due to Sri Lanka’s trade model, the majority of its exports by value go to markets in North America and Europe, while the lion’s share of its imports come from Asia. That the country has had such success targeting distant, wealthy and competitive developed markets for its exports is an often-overlooked indicator of its strengths, with a strong output of high-quality goods. While some Asian countries produce low-value exports that struggle for market share, Sri Lanka has broadly held its own.

The US remained the leading export market for Sri Lanka in 2015, the most recent year for which statistics are available, accounting for 27% of all exports, up from 25% in 2014, and rising 2.9% overall to $2.81bn, according to the CBSL. The US accounted for almost half of Sri Lanka’s textile exports, or 46.3%, having overtaken the EU as the industry’s most important market in 2007. Another major market for textiles is the UK, where this sector accounted for nearly 80% of Sri Lanka’s total garment exports.

Exports to India accounted for 6.1% of the total, a relatively small amount given the proximity of the vast market to Sri Lanka, and rose 3% to $643m, with spices, transport equipment and animal fodder being among the main exports. Sri Lanka’s deepening ties with China are also benefitting exporters, with the Asian giant leaping from 13th to sixth-largest export market in 2015, largely due to rising sales of tea, transport equipment and garments.

India continued to be the main source of the country’s imports, accounting for 23% of the total in 2015, rising by 6.1% to $4.27bn. The increase was largely attributable to a spike in the import of vehicles following a reduction of import duties in accordance with Sri Lanka’s 2015 budget. Passenger car imports from India increased 565.6% in 2015, which offset a sharp 20.3% fall in petroleum product imports from India, caused by lower oil prices. China’s share of Sri Lanka’s imports has also grown substantially in recent years, rising from 9% in 2010 to 20% in 2015. In 2015 imports from China rose 6.3% to $3.71bn, with base metals, machinery, building materials, fertiliser and textiles being among the leading goods.

Foreign Investment

FDI inflows have historically been modest, given the size of the country’s economy and its advantages in location, skills and costs. Estimates of FDI volumes differ widely depending on the agency providing the figures, but it is generally acknowledged that inflows rarely exceed 1-2% of GDP annually. FDI fell 54% in 2016 to just $450m, down from $970m in 2015, according to figures reported by local media. Malik Samarawickrama, minister of development strategies and international trade, was quoted in the local press in January 2017 as saying that the inflow was “extremely low by any standard”, and he further urged the Board of Investment to promote FDI and reduce the existing regulatory burdens where possible, adding that the current regulatory infrastructure had “failed to bring investors”.

Shiran Fernando, an analyst at Colombo-based Frontier Research, also told local media that some of the blame for this poor performance lies with inconsistencies on policy, including the government’s about-face on a number of tax policies implemented under the 2016 budget that were then withdrawn after protests.

Speaking in February 2017, Indrajit Coomaraswamy, governor of the CBSL, emphasised the importance of boosting FDI as a form of non-debt-creating capital inflows to ease pressure on the balance of payments, a growing concern for the authorities and investors alike. However, Coomaraswamy also highlighted investment opportunities that could arise from privatisations, including the 2016 sale of Hambantota Port and the divestment of non-strategic state assets. The governor added that these could bring in up to $2bn, which could then be used for liability management, reducing the burden of debt servicing.

Doing Business

The challenges that Sri Lanka faces in improving its business environment are apparent from the country’s slide down the World Bank’s ease of doing business index. In the “Doing Business 2017” report, the country ranked 110th out of 190 countries, down one place from 2016. While this low-middle ranking is comparatively respectable for an emerging market that was until a few decades ago a closed economy and is less than a decade out of a debilitating war, as recently as 2013 Sri Lanka ranked 81st, having worked its way up the table from 105th in 2010.

In 2017 the country scored particularly poorly on enforcing contracts (163rd), paying taxes (158th) and registering property (155th). However, it ranked better on trading across borders (90th), dealing with construction permits (88th), getting electricity (86th) and resolving insolvency (75th). There are also signs that Sri Lanka is already making progress in improving the business environment in some areas: it ranked 42nd for protecting minority investors, up nine places from 2016, and 74th for starting a business, up 21 places from the previous year.

Major Partner

India, a market of 1.3bn people just 50 km away from the north of Sri Lanka across the Palk Strait, is naturally one of the island’s most important trading partners, with bilateral flows totalling around $4.9bn in 2015. Relations between the two countries have generally been good, but there have been tensions in the post-independence era over India’s involvement in the civil war, and, more recently, smaller disputes over issues such as fishing rights.

The India-Sri Lanka FTA (ISFTA) implemented in 2000 has helped significantly increase trade between the two countries, and allows Sri Lankan companies to export more than 4000 types of goods to India duty free. Negative import assignments are favourable to Sri Lanka, which has 1180 items on its negative list, compared to India’s 429. Garments and tea are on the negative list, but can be exported to India under existing quota systems. Prior to 2000 Sri Lanka’s exports to India averaged a meagre $39m per year; however, this grew to $643m in 2015.

The ISFTA has particularly benefitted Sri Lanka. In 2000, 16% of Sri Lanka’s $55.6m worth of exports to its neighbour were under the FTA, a proportion that increased to 65% of $500m by 2013, according to a May 2015 report by local financial media outlets. Meanwhile, India’s exports to Sri Lanka under the FTA rose from 9% of the total to just 13% over the same period. Sri Lanka’s exports under the FTA grew by 877% between 2000 and 2013, while imports from India covered by the agreement grew by 415%.

The value of India’s exports to Sri Lanka remains heavily affected by international oil prices, while Sri Lanka has used the ISFTA to diversify its range of exports to India, including products such as value-added tea, higher-value garments, furniture, tableware and machinery. Partly as a result of this, Sri Lanka’s trade deficit in goods covered by the FTA has shrunk from 6.2 times to 1.1 times.

New Deal

An upgrade to the ISFTA, under a proposed Comprehensive Economic Partnership Agreement, was originally due to be signed in 2008. However, the proposals were criticised by representatives of the Sri Lankan services sector, and manufacturers in particular, as they feared the deal could expose them to fierce competition from lower-cost Indian players.

As a result of these objections, the government of then-President Mahinda Rajapaksa backed out of the agreement. However, in August 2016 the two countries began negotiations on an Economic and Technical Cooperation Agreement (ETCA), which is being strongly backed by the Ceylon Chamber of Commerce. The new proposed deal is seen as mutually beneficial, opening Sri Lanka to further investments by Indian companies, including those looking to export to Pakistan, with which India itself has a troubled relationship. The ETCA would also give Sri Lanka-based manufacturers more opportunities to feed into the Indian manufacturing supply chain. “As an island nation, Sri Lanka must be open to global trade for the long-term benefit of the economy. This will also enhance the country’s chances of linking into the lucrative stream of Indian value chains,” Mark Prothero, CEO of HSBC in Sri Lanka and the Maldives, told OBG.

Ties With China

Deepening relations with China have been a defining feature of trade and investment over the past few years, and were a central strategy of the Rajapaksa government’s foreign and economic policy. Further trade and investment with China is set to strengthen under the “One Belt, One Road” initiative, which includes Colombo as part of the maritime route. Investments include the development of Hambantota Port on the south coast, a project valued at $1.5bn in total. The $361m first phase was 85% funded by the Export-Import Bank of China (EXIM Bank), while the $810m second phase is due to be financed by the China Communications Construction Company (CCCC). Other Chinese-led projects include: the first phase of the Mattala Rajapaksa International Airport, which will be funded by a $209m Chinese loan; the $272m EXIM Bank-financed first phase of the Southern Railway; and the $500m Colombo South Harbour container terminal. In 2013 Sri Lanka’s government signed a deal with the CCCC for the construction of the long-mooted Colombo Port City (CPC), a $1.4bn mixed-use development on 230 ha near the existing port, the country’s single biggest investment project.

However, with the election of President Maithripala Sirisena in 2015, a number of major projects that were approved by the previous government were put on hold, largely due to the pressing need for fiscal tightening and a desire to reappraise the last government’s infrastructure decisions. In April 2016 Reuters reported that the government asked the CCCC to recommence work on the CPC project.

Then, in October 2016 Sri Lanka’s government announced that it had agreed to sell an 80% stake in Hambantota Port to China Merchants Holdings under a 99-year lease for an estimated $1.1bn. The deal is linked to 6000 ha of land around the port that will be developed into a Chinese economic zone, with the aim of attracting $5bn in Chinese investment over the coming three to five years. Although the deal has proved controversial, with protests taking place in early 2017, it could be key to Sri Lanka making the most of its substantial upfront investments in the Hambantota region and its aims of developing as a transcontinental shipping and services hub. The government has also said that it will use the money raised to pay down some of its debt.

Preference Play

In 2010 the EU revoked Sri Lanka’s preferential access to its market under the Generalised System of Preferences Plus (GSP+), which allowed the country to export more than 6000 products to the union duty free. The decision was based on the EU’s judgement that Sri Lanka was failing to honour commitments to ratify and implement several UN conventions on human rights, labour conditions, good governance and environmental protection. However, due to the Sirisena government’s commitment to having GSP+ restored, the EU announced the reinstatement of GSP+ benefits in mid-May 2017, enabling Sri Lankan exporters to enjoy duty-free privileges, following an appraisal of the country’s performance on a total of 27 international conventions. Sri Lanka will now regain the full removal of duties on 66% of tariff lines, including key export sectors such as fisheries and textiles. However, the country will still be subject to ongoing EU monitoring to ensure that it meets the prerequisite standards.

Singapore

Sri Lanka is gearing up to sign an FTA with Singapore in late 2017. Negotiations for the Sri Lanka-Singapore FTA began in July 2016, with Samarawickrama signing a joint statement with his Singaporean counterpart. Investors from Singapore are already active on the island, with a total of $102m of FDI in 2014 alone, making the city-state one of the top five foreign investors in Sri Lanka. Areas of interest for Singaporean investors reportedly include urban planning and infrastructure, not least of which is the planned Western Region Megapolis, as well as tourism and manufacturing. Bilateral trade between the two countries is substantial, at $2.05bn in 2015.

Thai Ties

Sri Lanka is set to ink another FTA with Thailand in an August 2017 visit from a Thai trade delegation led by Somkid Jatusripitak, the deputy prime minister. The agreement contains the goal of tripling bilateral trade to $1.5bn over the next five years, and attracting Thai investment to sectors such as jewellery, electronics and consumer products.

Thai officials are interested in establishing an industrial zone similar to the Thai-led public-private Thilawa Special Economic Zone in Myanmar. They are also encouraging Thai investors to take advantage of Sri Lanka’s FTAs with India and Pakistan, and to leverage the relatively affordable labour. The two countries have signed letters of intent to develop small and medium-sized enterprises, as well as tourism.

Trade between Thailand and Sri Lanka is heavily slanted towards the former at present, with just $39.9m of Sri Lankan exports going to Thailand in 2016 against imports from Thailand tallying $436.9m. Total bilateral trade dipped 2.3% to $436.9m that year.

Outlook

While navigating through 2017 and beyond, there is renewed momentum behind Sri Lanka’s efforts to achieve its potential as a regional trading centre and an attractive place for investors from around the world to come and conduct business.

The country is being proactive and positioning itself as such by seeking closer ties with India and China, other emerging markets, the EU and its traditional export partners. FTAs will certainly play an important role in boosting mutually beneficial trade flows and encouraging foreign investment.

Measures to improve the business environment, such as putting the country on a sounder macroeconomic footing and simplifying procedures, will also help Sri Lanka to make the most of its enviable geographical and demographic competitive advantages. A strong emphasis on sectors in which it is particularly well-placed to grow – such as logistics, garment manufacturing and tourism – are now starting to bear fruit.