The hopes and expectations of sustaining the current rate of economic growth and raising it to a still higher trajectory of growth would depend on whether the country would be able to attract adequate foreign and domestic investment. A small country can only develop with significant amounts of foreign direct investment of the right types. Therefore an investment climate that is attractive for foreign investors is vital strategy for the country's economic development.
Inducing foreign investment is important for several reasons. Foreign direct investment brings with it export markets, advanced technology and management skills. In due course there would be a transfer of technology that would increase the economic efficiency and capability of the country. Despite this paramount need, the country has taken some backward steps towards making the business climate less attractive to both local and foreign investors. Recent assessments of the country as a risky destination for investment would deter foreign investors. This is a serious setback to the country's long term economic development.
Importance of investment
Investment by and large determines economic growth. This is one of the few propositions in economics that are not contested. This is so whatever economic system prevails. It is as applicable to a socialist economy as to a capitalist one. The difference in these two systems of political economy is that while in a socialist economy investment is undertaken by the state that owns and controls the commanding heights of the economy, in a capitalist economy investment decisions are taken mostly by private investors. Nevertheless in both systems it is largely the rate of investment that determines the rate of economic growth.
However, the rate of return of the investment in each economy is determined by a host of conditions which are summed up in terms such as the efficiency of capital, productivity of investment, capital: output ratio or the incremental capital output ratio (ICOR). The efficiency of capital is dependent on the state of infrastructure, human capital, work ethics, organisational efficiency, the legal framework and investment climate, among others. Therefore, while a host of factors determine the productivity of investment these conditions are fixed at any given time and, therefore, it is the rate of investment that determines economic growth.
Nevertheless the improvement of these other conditions would result in an improvement in the efficiency of capital. It is for these reasons that developed countries have a higher efficiency of capital. In the longer run, the conditions that influence the efficiency of capital must be improved and over time higher economic growth can be achieved by both higher investment and improvements in the efficiency of capital.
The implications of this discussion for economic growth are that the country must increase the rate of investment if it is to move to a higher trajectory of growth and that to achieve a higher rate of investment there are a host of conditions that must be fulfilled to attract investment that is summed up by the term investment climate.
Several recent assessments of the country as a destination for foreign investment have been unfavourable. Initially the Fitch rating downgraded the country and said it was a risky place to do business. The latest Index of Economic Freedom compiled by the US-based Heritage Foundation and the Wall Street Journal said that although significant gains have been made, weak rule of law and heavy state-presence in economic activity continue to dampen private-sector-led development.
This assessment is no different to that of the local business community and many independent economists.
The latest US-based Index of Economic Freedom is not without a good word for the improvements in the country. Its report stated, "Sri Lanka's economic freedom score is 58.3, making its economy the 97th freest in the 2012 Index. Its score is 1.2 points higher than last year, reflecting solid gains in trade freedom, monetary freedom, and business freedom. Sri Lanka is ranked 16th out of 41 countries in the Asia-Pacific region, and its score remains below the world average,"
It notes several positive developments when it says that notable changes have been implemented in key areas. It recognises that regulatory efficiency has been considerably enhanced through establishment of a streamlined business formation process and simplification of licensing requirements. Further, it notes that non-tariff barriers are relatively low, statutory tariff rates have been reduced, and many import surcharges have been eliminated.
Yet despite these improvements overall business confidence has weakened. The New York Times-Washington Post report said that despite some gains in economic freedoms the setbacks were greater. It said: "Nevertheless, challenges to economic freedom in Sri Lanka are considerable, particularly in strengthening the fundamentals. Property rights are undermined by an inefficient judicial system that remains susceptible to substantial corruption and political influence. The heavy state presence in the economy continues to hamper private-sector development."
Three aspects of government economic policy have been responsible for the deteriorating business confidence on Sri Lanka. The attempt to state control the economy is foremost among them. The takeover of previously privatized economic entities, the state ownership of business enterprises, mainly banks, by government agencies buying into them and taking control of governing boards and the legislation to take over so-called underutilized and underperforming enterprises have led to fears of state interference in the economy.
These three actions of the government have resulted in fears of government taking over private businesses and questioned whether the private sector has much of a role in the country's development. The role of the government in the economy is growing and the business community intimidated. The role of the private sector is being eroded by these measures.
The blow to business confidence owing to these state actions is severe and the matter needs to be redressed by the government. Assurances alone are unlikely to correct the situation. Some significant concrete policy changes are needed to restore business confidence.
Rule of law
Although the biggest obstacle to foreign investment was removed two and a half years ago, the relatively peaceful conditions have not been accompanied by the rule of law and law and order in the country. This is another severe deterrent to foreign investment in particular.
The Index of Economic Freedom compiled by the US-based Heritage Foundation and the Wall Street Journal said: "The judicial system is weak and vulnerable to political interference. The commercial court system is subject to extensive delays that often lead investors to pursue out-of-court settlements. A fairly reliable registration system exists for recording private property, including land and buildings, but fraud and forged documents are problems. Mistrust of government is considerable due to widespread public-sector corruption."
The rule of law and the establishment of law and order are fundamental prerequisites for economic development. The national and international perception is that there is deterioration in implementation of the rule of law. Lawlessness is a common occurrence and threats to life and property are threats to economic freedom and serious deterrents to investment.
Sustaining the current rate of economic growth and raising it to a still higher trajectory of growth would depend on attracting significant amounts of foreign direct investment of the right types. Therefore, an investment climate that is attractive for foreign investors is vital strategy for the country's economic development. Some of the current economic policies and the law and order situation are serious disincentives to foreign direct investment of the right type and adequate amounts.
Foreign investment in the hospitality trade has been significant. This would boost not only the current balance of payments through the capital inflows for purchase of property, but also increase tourist earnings in due course. Yet, what the country really needs are investments in industry that would bring in advanced technology that would result in the transfer of technology to the country. Without such enhanced foreign investment it is not possible to achieve a high trajectory of growth.
Recent international assessments of the country as a risky destination for investment would deter foreign investors. This is a serious setback to the country's long-term economic development. The unsatisfactory law and order situation that influences foreign investment could also affect investment. There is an urgent need to address these issues to ensure higher foreign direct investment that is needed for development.