New investment and trade agreements tap Sri Lanka's potential along busy shipment routes

Trade and investment activities in Sri Lanka benefit from the country’s location along busy Indian Ocean trade routes, abundant agricultural and industrial exports, and a young, skilled workforce. Just 19 km separate its southern-most port from a global shipping lane carrying two-thirds of the world’s oil and half of its container shipments. This makes local ports a natural staging post for cargo destined for India and Pakistan, with some 30% of the former’s container traffic currently trans-shipped through Sri Lanka.

The country has also been making strides in attracting international stakeholders to develop trade, transport and logistics infrastructure, becoming a major destination for foreign direct investment (FDI) in the process. Higher inflows have benefitted the broader economy, with 2018 being the highest year on record for FDI, attracting $2.3bn worth of investments.

The sector is not without its problems, however. The outlook for emerging markets has been dim, with US interest rate hikes impacting global trade balances. Sri Lanka has seen export growth lag behind GDP growth over the last few years, with sector professionals and government officials anxious to address this. A new export strategy has been developed, along with a major burst of economic diplomacy, to capture more of the world’s trade and investment attention.

Structure & 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 MODSIT are the Board of Investment (BOI), the Export Development Board (EDB) and the Department of Commerce (DoC).

The BOI is responsible for overseeing new investment 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 BOI has a particular focus on boosting FDI and is responsible for establishing investment-promotion zones.

The EDB acts as the executive arm of the Export Development Council of Ministers, its policy-making body, and is tasked with instituting the council’s initiatives in export promotion and development. The EDB is also there to assist Sri Lankan and Sri Lanka-based companies in expanding their overseas business.

The DoC, meanwhile, formulates foreign trade policy, promoting bilateral, regional and multilateral trade relations under four divisions: multilateral trade affairs, bilateral trade relations, regional cooperation and trade promotion. This gives the department a key role in international trade negotiations with bodies such as the World Trade Organisation and the EU. The DoC is also responsible for continuous monitoring and evaluation of free trade agreements (FTAs), preferential trading arrangements and comprehensive economic partnership arrangements.

Growing Deficit

As a developing economy with no commercially exploited oil and gas resources of its own, rising fuel imports have pushed Sri Lanka’s trade deficit to new highs. While Brent crude prices declined at the end of the year to around $51 per barrel, oil prices peaked in October at over $85, leading to a 28.9% increase in the fuel imports bill. Domestic exports, meanwhile, mostly involve intermediate and manufactured goods, as well as commodities, such as tea, rubber, minerals and metals. The chief locally manufactured goods are textiles and garments.

The growing trade deficit shows no signs of slowing, increasing from $2.88bn in the first half of 2016, to $4.75bn at end-June 2017 and $5.7bn as of the first half of 2018. Provisional data for the month of November 2018 from the Central Bank of Sri Lanka (CBSL) showed that the trade deficit had increased from $999m in November 2017 to $785m in October 2018.

Import Challenges

In addition to rising oil and gas costs, a number of other factors have contributed to the imbalance, including an increase in automobile and gold imports, as well as the depreciation of the Sri Lankan rupee against global currencies.

Although some microcars are manufactured locally, vehicles constitute a major source of imports. During the first half of 2018 the value of automotive imports increased by 119.5% year-on-year (y-o-y), according to the Colombo-based JB Securities Research.

The hike was attributed to an increase in the sale of vehicles with reduced costs. This included showroom vehicles, which are classified as second-hand and thus able to avoid import duties; imported vehicles for public servants, which are granted concessionary rates; and hybrid and electric vehicles with lower duties. With such imports soaking up foreign exchange reserves, in August 2018 the authorities moved to impose higher taxes on imported vehicles. Then, in September, it banned the import of all vehicles by government institutions for one year. These measures had the intended effect, with spending on personal vehicle imports declining by 34.8% month-on-month in November 2018, the CBSL told local press.

A third contributing factor was gold, which saw a 59.2% rise in import value during the first half of 2018. This encouraged the government to impose a 15% tax, as well as police action after investigations revealed that imports might be spiking due to smuggling across the narrow straits separating the country from India.

The impact of all three of these factors, however, was exacerbated the most by the depreciation of the Sri Lankan rupee throughout the year. CBSL figures show that during 2018 the currency fell 16.4% against the US dollar, 12.7% against the euro, 11.4% against the pound sterling, 18.1% against the Japanese yen and 8.7% on the Indian rupee. Early 2019 did see some recovery, with the rupee up 0.6% against the US dollar in January, 0.8% against the euro and 2.1% against the Indian rupee, yet the slide continued against the pound sterling and the yen, depreciating by a further 3.2% and 0.3%, respectively. With the majority of goods priced in foreign currencies, rises in imports contributed to significant drains on the country’s foreign exchange reserves. This was a particular concern given the stiff debt-repayment schedule the country faced in 2017-18 and continues to face into 2019.

Export Performance

The performance of exports varies by sector. CBSL figures show monthly industrial exports rising from $725m in October 2017 to a peak of $861.1m in March 2018, before drifting down to $774.9m in November 2018 – albeit still up on the year. Textiles and garments saw exports grow from $422.6m in October 2017 to $486.8m in March 2018, before moderating to $462.1m in November 2018.

Agricultural exports, meanwhile, totalled $2.32bn in the first 10 months of 2017, declining to $2.17bn in the same period in 2018. This was partly the result of a deterioration in global commodity prices, with tea – the sector’s chief export – earning the country $136.2m in October 2017 but $115.5m in October 2018. Global tea prices fell 15.8% in 2018, according to research by India-based CARE Ratings.

This performance is in line with the forecasts made in OBG’s Business Barometer: Sri Lanka CEO Survey, published in February 2018, which saw 77% of Colombo-based CEOs predict that the garments industry would be the growth engine for exports in the year ahead, followed by tea and spices at 14%.

Indeed, in 2017 the top exports were textiles, which accounted for some 47% of the total; followed by other industrials (17%); tea (12%); rubber products (7%); coconut products (4%); other agricultural goods including spices (3%); gems, diamonds and jewellery (3%); and refined petroleum (3%). These exports are mostly destined for developed economies. Leading export destinations by value include the US, with a 24.9% share, followed by the UK with 8.9%, India (6.7%), Germany (4.7%), Italy (4.5%) and China (3.7%).

Despite the close proximity of India, Pakistan, Bangladesh and Nepal, intraregional trade accounts for less than 5% of all trade in South Asia. This is partly due to limited logistics, major regulatory barriers and protectionist policies, as well as the disproportionately high cost of trade in the region. According to the World Bank, South Asian trade costs 20% more than it does within the Association of South-east Asian Nations. Although the South Asian FTA (SAFTA) has existed since 2006, para-tariffs have discouraged activity.

Foreign Investment

To address some of the issues presented by the deficit, as well as further the country’s goal of achieving upper-middle-income status by 2025, officials are encouraging FDI. The year 2017 was a record year for investment inflows, with the country attracting $1.91bn in FDI, up from $1.08bn in 2016.

“There was considerable momentum in foreign investment generated in 2017, bringing us out of the doldrums of the previous year. This growth has continued into 2018,” Prasanjith Wijayathilake, executive director of investment promotion at the BOI, told OBG. Indeed, FDI totalled $1.4bn in the first half of 2018, a y-o-y increase of 101%. Government officials suggested in January 2019 that total FDI inflows for 2018 could reach $2.2bn, marking another record year.

The top country of origin for inflows in 2017 was China, which accounted for 35% of the total, followed by India and Singapore. Some 31.6% of Sri Lanka’s FDI total went into real estate, 20% went into manufacturing and 18.5% into the services sector.

While the growth in FDI is impressive, Sri Lank is still behind its regional peers in terms of FDI as a share of GDP. In 2017 FDI inflows comprised 1.6% of Sri Lanka’s GDP, compared to India at 2% of GDP, the Philippines (2.7%), Myanmar (5.2%) and Vietnam (6.1%). Only Bangladesh was lower, with 1.1% of GDP.

Free Trade

In addition to boosting FDI, Sri Lanka is promoting exports and trade liberalisation. It enjoys a Generalised Scheme of Preferences (GSP) status with the US, Russia, Japan, Canada, Australia and Turkey, and GSP+ status with the EU (see analysis). In addition, the country is a signatory to the India-Sri Lanka FTA (ISLFTA), the Asia-Pacific Trade Agreement, the Global System of Trade Preferences among Developing Countries, the Pakistan-Sri Lanka FTA and SAFTA. In 2018 the Sri Lanka-Singapore FTA was also signed, yet will likely undergo further changes before being brought into effect (see analysis).

Officials are engaged in enhancing existing trading arrangements. The ISLFTA has been a great benefit to the country – in 2017 around 64% of Sri Lanka’s exports to India were covered by the agreement, although only 6% of India’s exports to Sri Lanka were – with talks ongoing to try to widen Indian uptake. Negotiations over the proposed Economic and Technology Cooperation Agreement between Colombo and Delhi are part of this process, with a review of non-tariff measures under the ISLFTA taking place. Some 11 rounds of talks had taken place as of January 2019.

At the same time, SAFTA is undergoing changes. The 2004 agreement brings together Sri Lanka, Afghanistan, Bangladesh, Bhutan, India, the Maldives, Nepal and Pakistan to reduce both tariff and non-tariff barriers. Yet, according to Indrajit Coomaraswamy, the governor of the CBSL, over one-third of intraregional trade under SAFTA is on the sensitive list, while border entry restrictions between Pakistan and India hinder the movement of goods and prevent regional integration.

In the Pipeline

A number of FTAs were in the negotiation stages in 2018, including two round of negotiations with Thailand. In addition, Sri Lanka and Indonesia have agreed to a joint feasibility study to explore the possibilities of an FTA, which would connect local businesses with the largest economy in South-east Asia.

Agreements with Malaysia and Bangladesh have also been floated, with the former expressing “strong interest” in moving forward with such an agreement, according to local media. Malaysia was the seventh-largest source of Sri Lankan imports in 2017. Negotiations with Bangladesh have reportedly reached more advanced stages. An agreement to finalise an ongoing feasibility study was signed in October 2018, with a view to rapidly move on with FTA negotiations. The eventual agreement is expected to cover the services sector and investment. In 2017 Bangladesh exported $30m worth of goods to Sri Lanka, while $47.8m went the other way.

However, not all pending FTAs are proceeding as planned. The China-Sri Lanka FTA has seen several rounds of negotiations since the two countries began working together in 2014. Talks stalled in June 2018 after a disagreement over a Sri Lankan requirement to review the deal after 10 years, as well as a Chinese requirement that there be outright liberalisation of tariff lines, rather than the phased approach favoured by Sri Lanka. As of January 2019 no date had been set for a resumption of talks, but Sri Lanka was in the process of appointing a new negotiating team. Although challenges remain, 2019 may see this process back on track.

Export Strategy

In 2018 the EDB launched its five-year National Export Strategy (NES), which focuses on four pillars: export diversification; leveraging geostrategic advantages to become an efficient trade and logistics hub; strengthening market entry and compliance practices for Sri Lankan exporters; and creating a policy and regulatory framework that is transparent, predictable and business-enabling.

According to UK Dayani Wegapitiya, director of policy and strategic planning at the EDB, the NES will focus on six sectors: spices and concentrates; processed food and beverage; electrical and electronic components; the boat-building industry; wellness tourism; and IT-related business process outsourcing. Specific goals in the NES seek to raise value-added processing in the targeted sectors by 2022, with a focus on exporters, while introducing and developing soft and hard infrastructure to benefit these industries. “Regulatory problems affect exports,” Wegapitiya told OBG. “So we have looked at each sector, clarifying and reforming regulatory problems. We also involved the heads of relevant authorities to address certain key issues.”

These reforms have included securing funding for a food safety authority – which is vital for the food and beverage segment – and new regulations regarding coastal waters for recreational craft to help diversify boat building away from commercial vessels to higher-value-added leisure craft.

The NES surpassed its $17.4bn export target by $400m in 2018. Efforts are likely to continue in the coming years, with a $20bn export target set for 2020.

The EDB and the MODSIT also launched a number of other export-promotion initiatives in 2018. The Market Access Support Programme debuted in July and seeks to help businesses develop their products to meet the standards required of particular overseas markets. Meanwhile, the Arambuma Credit Scheme, which came on-line in June, looks to assist start-ups with innovative products. Under the programme, financial support is made available for such enterprises to encourage the export of their products. Linking to the Arambuma Credit Scheme, the Enterprise Innovation Scheme will also encourage the development of new ideas and products for export when it launches in 2019.

Outlook

While future trade and FDI will likely be affected by factors such as the Chinese economic slowdown and the US-China trade war, changes in Sri Lanka’s domestic political and economic landscape also have a major role to play in shaping the 2019-20 outlook. Elections loom large, with the macro-environment likely to see some fiscal easing as a consequence. Nonetheless, the government is determined to press ahead with its strategy for opening up the economy to international trade and FDI flows, while the NES pulls together sector stakeholders to address a range of outstanding issues. Moves to reduce protectionism and develop the regulatory frameworks necessary for boosting trade are thus under way, with the years ahead likely to see Sri Lanka move closer to its goal of becoming a regional trade and investment hub.