Business Times

Urgent need to improve Balance of Payments

Rapid export expansion

By Lloyd F. Yapa

The annual report of the Central Bank (CB) for 2011 indicates that the value of imports last year was over US$ 20 billion, while exports earned only US$ 10.6 billion, creating a massive negative balance of trade. Sri Lanka (SL) needs sufficient foreign exchange to import goods and services not produced domestically; the country cannot afford to borrow to fulfill these requirements.

Therefore government moved to plug this leak by levying certain taxes, restricting bank credit and changing over to a flexible exchange rate to enable the expansion of exports by making them cheaper to buyers abroad and rendering imports more expensive, in terms of rupees. However, merely by opting to a flexible exchange rate, earnings from exports cannot be increased significantly; it requires a package of policies to be applied concurrently and consistently.

The purpose of this paper is to deal with some of them. Why export? Besides enabling the earning of foreign exchange, it has to be stated that exporting may be the only way available for a small country like SL to achieve a long term higher rate of economic growth; the high rates of economic growth enjoyed by the country currently may be mainly due to stimulation of domestic demand.

Establishment of export oriented enterprises especially in manufacturing could create plenty of employment opportunities for those entering the job market, those who give up their jobs due to improvement of productivity as well as the under-employed, as there is no limitation to such capacities when catering to the world market, unlike in the case of the small domestic market. It also has to be stated that currently exports though growing satisfactorily constitute only about 18% of GDP, a steep drop from more than 31% of GDP in 1998; SL may have to reach beyond this target for exports to have a significant impact on income growth.

Productivity and Innovation
Michael E Porter the author of the book 'The Competitive Advantage of Nations' says "governments' focus on improving the aggregate trade balance through wage controls, currency intervention, controlling far from decisive in shaping long term competitive advantage ". He goes on to say that "policies.with short term effects...such as subsidies, protection" etc. "will dampen innovation and erode average productivity in the economy"; such policies will perpetuate competition on the basis of prices as in the case of certain SL exports (and therefore low wages).

In this statement he also indicates what needs to be done - improvement of productivity (increasing outputs and earnings with lower inputs) especially through innovation (development of a new product, service or process for improving efficiency and to add value to products on the basis of customer preferences and differentiation to prevent copying by competitors).

The task of improvement of productivity for improving competitiveness in a country is the direct responsibility of the private sector; a government is indirectly responsible except in areas such as the creation of a policy environment conducive to such an effort, construction/maintenance of infrastructure facilities and development of education where the private sector is normally reluctant to act.

Dynamic, enabling environment
The main task of the government is to create an enabling environment in which firms could upgrade themselves by improving their productivity through innovations for higher earnings. Firstly, it involves the building of a wholehearted and united national consensus for achieving economic success and a willingness to take risks to make investments which are necessary for increasing production capacity and to improve productivity.

This preparedness among the people has no doubt to be achieved by, (a) improving governance and b) building communal harmony in this multiracial society, to leave behind a lack of motivation for a leap forward. There should be no delay in forming this consensus, as the whole process of upgrading would take a couple of decades depending on its consistency.

Secondly, the creation of an enabling environment involves reform of certain policies which will have a long term effect. There are basically four areas of policy involving productivity improvement. They are connected with, (a) firm strategy and rivalry, (b) creation/development of factors such as labour, capital and land, (c) supporting industries and (d) demand conditions. Porter emphasizes the need for leaders of companies and governments to be active consistently in all the four areas at the same time for a couple of decades for this effort to be effective; the neglect of even one area could lead to failure of the entire effort.

Firm strategy
The most important policy measure that the government has to implement is to liberalize trade to enable firms to operate on a global basis primarily to achieve economies of scale (to reduce unit costs and invest in long term innovation efforts, e.g. in research and development-R&D) by reducing barriers such as the various levies, procedures and documentation at the point of import; (at the point of export the country has removed most of these barriers in the '80s and the '90s).

This does not, however, mean protection has to be reduced to zero; a low level of protection could be offered for a specific period to enable new firms to establish themselves; the problem, however, is that firms invariably get this protection extended by appealing to politicians; this is why an independent and neutral meritocracy is needed in a country to take firm decisions like stopping the protection at the end of the period allowed and to maintain these policies consistently over the long term.

Companies would normally want to make profits without making the rather painful effort of undertaking productivity improvements by appealing to the government for import tariff protection against competitors, for subsidies (and Treasury grants).

But this strategy would help neither the organisations nor the country to expand exports and create jobs. It would not help the companies, as they would be struck down by their global competitors who would be steadily upgrading themselves to improve productivity and competitiveness to the highest levels possible, pressurized by their governments.

Consumers here who are in a majority also will eventually take their political masters to task for allowing the production of shoddy and costly goods and services under protection, as in the '70s. So it is better for companies both in the private and public sectors here to give up demands for protection, to prepare them for upgrading productivity right now, though it may be quite uncomfortable for them.

A very important intention of reduction of protection is to pressurize companies to do so by making them compete against (a) global enterprises, and, (b) against domestic firms, which competition is encouraged by anti trust laws against collusions /horizontal integrations such as monopolies, mergers and alliances (which may result in increases in consumer prices and lowering of quality); it could, however, be beneficial to incentivize vertical collaboration among suppliers, distributors and buyers of companies in their value chains to achieve economies of scale and to enhance competitiveness. Without this element of strong competition among companies, they are likely to go easy on productivity improvements.

It is also essential to incentivize companies to invest in, (a) expanding production capacity and (b) undertaking R&D and training of employees etc for raising productivity, by adopting a low and simple tax regime on profits from export operations (after the expiry of tax holidays), long term capital gains on equity/ investments and on reserves of a firm; matching funds / sharing costs for the latter type of activities are recommended, rather than tax deductions, which are not monitored.

Provision also has to be made to attract reputed FDI who possess the required technologies, skills and global market access; attracting them will depend on the dynamism of the enabling environment. Expatriates who are employees of these may also be exempted from income taxes as a part of the FDI attraction drive and to differentiate against competitor countries.

The total investment required for this capacity building and productivity upgrading effort is estimated at more than 35% of GDP (against the present figure of 28%) including a government contribution of more than the current 6% of GDP; presently GDP is Rs 6.54 trillion.

Creation/development of factors
The most critical area of government activity for improvement of productivity in SL is development of human resources through primary and tertiary education including universities and technical colleges. Sadly, SL has failed to reform education even after three years of the defeat of the LTTE, to create the scientific, technical, managerial and marketing skills as well as proficiency in English necessary for a leap forward in innovation to improve productivity to compete successfully in global markets. Foreign-skilled persons where such skills are not available locally may have to be attracted, while incentivizing highly trained local persons with relevant skills to stay and work in the country; the enabling environment should be such as to attract even our skilled Diaspora to come back preferably with some capital.

Investment in education has to be increased; SL hardly spends 2% of GDP on education, vs. more than 6 % of GDP in Malaysia some time ago. Since the government is short of capital for such purposes the private sector has to be incentivized to set up schools, universities, technical colleges especially those teaching science, technology and management and start apprenticeship and in-house training programmes, preferably in collaboration with reputed foreign institutions concerned without being distracted by selfish protests by uneducated persons.

Education and training will also have to be infused with a practical orientation in line with global requirements of trade by revising syllabuses in consultation with the trade associations and employers. Intellectual property rights acquired through generation of innovations by such efforts must also be protected by strong patent rights. It is equally important to make teaching the most prestigious of professions, while increasing the remuneration of teachers.

Since increasing their salaries in government schools and universities would upset the entire public sector salaries/wages structure, it might be appropriate to add generously to their incentives and allowances such as for research, training (which in case is essential to improve teaching standards), purchase of vehicles, housing and the like, these also being necessary to attract the best to the field.
In the development of factors it will also be necessary to make capital available on easy terms to the firms engaged in international trade through an efficient and reliable banking system.

For this purpose it will be necessary to encourage the savings habit particularly by keeping the rate of inflation lower than the rate of interest so that interest income is not eroded by rising costs and prices. Other factors of production that should be developed include land through land reform/ company formation among farm owners to realize economies of scale, infrastructure of all kinds and information for diffusion of knowledge on policies, technologies, competitors and markets. Supporting industries Enterprises that support firms are those in the value chain like input suppliers, distributors and buyers.
Successful firms collaborate with them vertically to achieve economies of scale for reducing unit costs and improve quality and competitiveness. Governments could assist in these efforts especially by setting up industrial estates/ free trade zones provided with basic infrastructure like roads, power and water supply facilities and by locating in them, research universities and even foreign direct investors producing similar goods to serve as models. These are also called clusters, which could be product specific eg in electronics and IT like in the case of the Silicon Valley in California, USA.

Sophisticated demand conditions
The fourth area of improvement of productivity is raising the quality of domestic demand. The responsibility of the government in this connection is as a major buyer of goods and services to set product specifications/standards in line with the highest levels demanded or even anticipated elsewhere in the world so that domestic suppliers and exporters could be pressurized to get used to them. Governments could resort to the same strategy as regulators of product safety and safe working conditions, while simplifying the process of administration of such regulations. Government could also assist or incentivize firms to adopt these standards as in the case of the very successful Deming Prize offered to Japanese exporters to improve the quality of their goods and services.

In the final analysis what determines the success of this productivity and export expansion effort is the quality of the enabling environment, which in the case of SL, since it has a small domestic market, depends both on the consistency of the above mentioned long term policies and on good governance consisting of politically neutral public institutions; further, success depends on finding a solution to the long-standing ethnic problem for creating peace and harmony in this multiracial society, so that a consensus and a motivation can be built for an economic take off.

A third essential element is for SL to live in harmony with the rest of the world as a good global citizen, in order to attract investments and opportunities for trade. In other words SL has to differentiate itself to be a nation which can be admired as one of the 'Wonders of Asia', only after which the journey involved would become short and sweet.

(The writer is an economist).

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