ISSN: 1391 - 0531
Sunday, January 07, 2007
Vol. 41 - No 32
Financial Times  

Where are the benefits of higher growth?

By D.N.R. Samaranayaka

According to statistics released by the Central Bank and the Department of Census and Statistics (DCS), the economy is poised for an above average growth rate in 2006 as well. The 7.4% growth rate expected in 2006 will be even higher than the growth rate of 6.3% in 2005.

The Central Bank also predicts a growth rate of over 7 % in 2007 but below the earlier target of 8%. A higher growth rate generates a higher production of goods and services of the economy and a higher per capita income, which is the value of goods and services per person in current market prices. Despite many shortcomings, per capita income is widely used as an indicator of the average living standard of the population. In 2005, for example, the average per capita income reached US$ 1,197 compared with US$ 480 in 1980 and this increase reflects a higher living standard at present compared to two decades ago.

Decline in unemployment is usually associated with the creation of new employment opportunities in the economy. Despite the tsunami catastrophe, which reduced an estimated 275,000 jobs in agriculture, tourism, fisheries and other sectors, the economy, according to the DCS, generated 124,000 net employment opportunities or nearly 400,000 jobs in 2005 in gross terms.

Although the growth rate signifies the overall economic performance, it is still a single number and, accordingly, it does not capture the impact of the growth rate at the regional level or on different segments of the population. The emphasis only on the growth rate is, therefore, meaningless without considering distributional aspects of economic growth. If the economic growth, for example, is concentrated in one sector or in a particular geographical region, the economic impact of the growth rate, even if it is around 10%, is very limited. A growth without much economic significance will also have very limited impacts on government revenue, employment, capital inflows, domestic investment, and export earnings, some of the key aspects that are positively influenced by economic growth. This article has selected a few aspects to determine whether the accelerated growth in the economy, as claimed by official sources, has any noticeable impact on the economy.

Government revenue
The revenue base in the country is dominated by a highly complex tax system. It is complex because it consists of a variety of taxes, duties, levies, surcharges, withholding taxes, tax on dividends, and special taxes which are introduced from time to time to raise revenue to meet revenue shortfalls. The complexity is compounded by the frequent introduction of new tax measures and changes to tax rates and exemptions. Most of these taxes are subject to changes every year either by increasing or decreasing tax rates or by narrowing or expanding the exemptions. Some taxes and charges such as the Value Added Tax (VAT) and Economic Services Charge (ESC) have been subject to changes every year since they were introduced a few years ago.

Frequent changes in tax rates and tax exemptions underline the characteristics of a weak revenue base in the country and the difficulty of raising revenue from the existing tax system. Some of the changes that have been introduced would have made little impact on the level or the composition of revenue. In most other countries a higher economic growth is a major source of higher revenue which in turn provides an opportunity to reduce the tax burden on tax payers. In Sri Lanka, on the other hand, the collection of taxes either from existing or new sources increases every year together with the tax burden. This is despite the claim that the economy is experiencing an unprecedented growth.

A review of the 2007 budget proposals indicate that there are no new revenue sources that could generate additional revenue of any significant magnitude. The expected increase of revenue of Rs 20 billion in 2006 and Rs 15 billion in 2007 largely results from the changes to existing tax system and from administrative reforms rather than growth related increases in revenue.

The present position is that the revenue collection from all domestic sources is not even sufficient to meet the recurrent expenditure of the government. Given this situation it is meaningless to use the budget deficit, which is usually expressed as a ratio to Gross Domestic Product (GDP), as an indication to judge whether the deficit financing is too excessive to adversely affect private sector investments, inflation and interest rates since the budget deficit only reflects the amount that the government could usually raise from financial markets; it does not reflect the funding requirements based on development needs. The government is compelled to adjust the spending need to maintain the defict within acceptable limits as dictated by international lending agencies.

According to the DCS, the unemployment rate dropped to its lowest level of 6.4% during the second half of 2006. If this employment rate measures the full employment level of the economy, then it is a clear sign of a very strong and vibrant economy. The full employment in most economically advanced countries is when the unemployment rate reaches around 6% and these countries usually do not attempt to bring this down any further since such interventions could increase wages, production costs and inflation which in turn reduce not only the competitiveness but also the growth momentum of the economy.

Decline in unemployment is usually associated with the creation of new employment opportunities in the economy. Despite the tsunami catastrophe, which reduced an estimated 275,000 jobs in agriculture, tourism, fisheries and other sectors, the economy, according to the DCS, generated 124,000 net employment opportunities or nearly 400,000 jobs in 2005 in gross terms.

The same source reports that between 2005 and the first quarter 2006, another 286,000 jobs have been created. The scenario that emerges from the DCS data on new employment opportunities leads to questionable conclusions since the sectors where the growth occurred in the recent past are not even major employment categories maintained by the DCS for the purpose of employment estimates. At the rate of current trends in employment generation, the country could reach zero unemployment within the next few years.

The rate of unemployment, as defined by the DCS, is measured in terms of employment by any person who works at least one hour per week either for pay or as an unpaid family member working for family business. In general full time employment requires at least 35 hours per week and all those who work less than this number is defined as employed in casual or temporary capacity. Out of the employed, nearly 30% is currently working for less than 40 hours. The inclusion of a substantial number of those working less than full employment within the definition of employed distorts the definition of employment.

Although the official rate of unemployment is currently 6.4%, a significant share of households in the country are recipients of welfare benefits from the government. In 2005, the number of families receiving Samurdhi benefits increased to 1,960,664 from 1,864,058 in 2004 while the value increased to Rs 9,294 million in 2005 from Rs 8,591 in 2004. Although this increase partly reflects the addition of tsunami-affected families to the programme, the absence of any reduction in the number of welfare recipients even before the tsunami is contrary to the relationship that is normally observed between rising employment and the number of welfare beneficiaries.

Export earnings
A comparison of Sri Lanka’s export performance in 2003 and 2004 suggests that it shares characteristics quite similar to the performance of the economies such as Maldives, Myanmar, Mongolia, Nepal and Papua New Guinea. Although export earnings of Sri Lanka are much higher than these nations, Sri Lanka falls in this category in terms of the average growth rates in export earnings. These countries experienced a growth rate of around 10% while fast growing medium sized economies such as Thailand, Singapore and Malaysia experienced a growth rate closer to 20%.

Export earnings in 2004 increased by nearly 12%, but declined to around 10% in 2005. In 2004 and 2005, export volume increased by 8% and 6.5% and unit value of exports by 9.5% and 2.5% respectively. On the basis of the first 10 months trade data, about 7% to 8% increase in export earnings is anticipated in 2006.

However this increase is also largely attributed to improved prices in international markets particularly for petroleum products and agricultural commodities such as rubber, tea, and coconut products. During the first six months for example, the volume of exports declined by 5.1% while the unit value of exports increased by 7.7%, leading to an increase of export earnings by 1.7%.
There is also no apparent change in the composition of exports. However, the share of export earnings from textiles and garments has declined to around 43% during the first six months in 2006 compared with 46% during the first six months of 2005 while agricultural exports increased to 19% from 18% during the same period.

Before the termination of the Multi Fiber Agreement (MFA) in 2005, the share of textiles and garments accounted for nearly 50% of export earnings. Based on trade data, there is no clear evidence that export earnings experienced a growth comparable with the above average growth in the economy. The increase in export earnings during the last few years reflect the effects of international price movements as well as the depreciation affects on trade volume.

Regional development
In 2004, the latest year with the regional breakdown of GDP, the Western Province accounted for an estimated 51.0% of the national GDP compared with 28% of the population share.

This means that 49% of the national output is shared by 72% of the population living in other provinces. The GDP share of the Western Province has been made up of 1.5% of the national output of agriculture, 16.5% of industry and 33.0% of services. The next highest contribution came from the Southern province and it accounted for 9.3% of the national GDP compared with its population share of 12.1%. Agriculture contributed 3.4% of the GDP share of the Southern Province, industry 1.9% and services 4.1%.

The lowest contribution of 2.9% to the GDP came from the Northern Province. The population share in provinces other than the Western province is higher than the GDP share and it explains the concentration of economic activities largely in the Western Province.

Both services and industry are heavily concentrated in the Western Province. In 2004, the Western Province accounted for 61.6% of the industrial output and 59.5% of the services output. All other provinces accounted for the balance 38% of the industrial output and 40.5% of the services output. In 2005, the Western Province accounted for 90% of the industries registered under the Ministry of Industries and 75% of industries established under the BOI approval. The high concentration of services in the Western Province is also indicated by the higher share of key services such as transport (58%), wholesale trade (60%) and banking (80%), which are the leading sub categories of the services sector. Given this significant disparity in economic development, the benefits of any increase in GDP growth, whether it is 3% or 10%, will be disproportionately distributed with the Western Province taking a major slice of the benefit.

The disparity in regional development is reflected in the variation of per capita incomes among the regions in the country. In the Western province, for example, the GDP per capita income in 2004 stood at Rs 166,178 and ranked as the province with the highest per capita income in the country.

The average per capita income in the Western Province in 2004 has been more than 80% higher than the average per capita income of Rs 92,526 for the country as a whole. The Northern Province, on the other hand recorded the lowest per capita income in 2004 with Rs 45,873 per year and it was 50% less than the national average. Average per capita incomes of all other provinces have been less than the national average with the Southern Province accounting for 76% and Uva 65% of the national average.

If per capita income is an appropriate measure of determining the living standard of the population, a higher per capita income can also be considered as an indicator representing higher living standard of the population. In this context, the living standard of the population in the Western Province can be regarded as higher than any other province.

The same criterion suggests that the Northern Province has the lowest living standard since its per capita income is the lowest in the country. All other provinces fall in between the living standards of these two provinces. Since per capita income is derived by dividing GDP in current prices, the regional variation in the production of goods and services is the key determinant of the variation in living standards across the provinces.

Some explanations for lack of noticeable economic impact
The sectoral composition of the economy appears to provide the explanation for the lack of evidence of any significant impact of economic growth. In terms of the sectoral composition, agriculture in 2005 accounted for 17.2% of GDP, industry 27% and services 55.8%. As the national income represents the monetary value of GDP in current market prices, these shares also represent the share of national income generated by each sector in 2005.

The services sector accounts for the highest share of the GDP composition as well as the contribution to the annual change in GDP. In 2005 services sector accounted for 55.3% share of GDP compared with 44.3% in 1977. Services also contributed to 70.3% of the change in GDP growth rate of 6.0% in 2003, 75.8% of the growth rate of 5.4% in 2004 and 59.3% of the growth rate of 6.0 in 2005.

In the case of industry, the contribution to the change in GDP growth rate has been 36.3% in 2005, 25.4% in 2004 and 24.3% in 2003.

Agriculture, on the other hand, contributed 4.4% in 2005, -1.2% in 2004 and 1.6% in 2003 to the change in GDP respectively.

The composition of services shows that the GDP share of 55.8% in 2005 was made up of (a) wholesale and retail trade, hotels and restaurants (21.6%), (b) transport, storage and communication (15.5%), (c) financial services, real estate and business services (11.7%) and (d) public administration and community services (7.0%).

These sub sectors, with the exception of the last category, experienced a faster growth in the last few years than the growth rate of the economy as a whole. In 2004, these categories accounted for 70% of the 75.8% change in the contribution to GDP while in 2005 it declined to 68% of the 59.3% ange in the contribution.

These figures show that economic growth is highly concentrated in the services sector, accounting for more than 60% of the annual economic growth rate. As demonstrated above, the growth in the services sector is further concentrated in wholesale and retail trade, transport and communication and financial services sub sectors. This growth pattern explains the lack of any significant impact of economic growth on the economy as a whole and also the high concentration of the growth in the Western Province where the services, particularly the sub sectors reported above, are mostly concentrated.

Although the services sector provide an important source of growth, its impact will be limited in countries such as Sri Lanka where the economies are characterized by poverty, regional disparity in development, high inequality in income distribution and a higher share of population living in rural areas dependent on agriculture or agriculture related activities. While the role of the services sector should not be undermined, a greater emphasis on industry and agriculture is equally significant to achieve a balanced growth and reduce regional disparity and rural poverty.

Services sector as a source of growth
Services cover a variety of intangible products and activities. The most common activities coming under services are wholesale and retail trade, hotels and catering, tourism, transport, health, education, telecommunication, property and rental, marketing and cultural and administrative services. Services are also divided into several categories. Most of the basic services are dependent on domestic demand which again is influenced by income of the population. Services are generally considered to be income elastic which means the spending on services rises more than the increase in income of the population. For example the increase in the demand for services such as passenger transport, telecommunication, catering services, travel and entertainment are all income related and as income goes up the demand for these services will go up much faster.
The Services sector has been the key contributor to the GDP in a large number of countries during the last two decades. In the case of economically more advanced nations, the GDP share is currently around 70% and, unlike in developing nations, it is much more diversified.

The recent advancements in Information technology has revolutionized the services sector leading to rapid expansion in many services including telecommunication, finance and insurance, health, education and travel and tourism. As a result of these developments, the cross border trade in services has grown steadily across geographical boundaries during the last two decades and a large number of countries, including some developing nations such as India, now account for a significant share of cross border trade in the total services output.

Technological advances in IT has reduced the distance between the supplier and the customer and as a result leading international firms are now outsourcing various activities such as data entry operations, software programs, processing of income statements and various other information processing activities. IT has also improved the after sale services and customer support in most of the manufacturing products produced for international markets especially by industrial countries and some of these services are also outsourced to developing nations due to cost advantage. This has led to a closer integration between manufacturing and services, thus benefiting both sectors mutually.

Among the services, telecommunication, education and health services have currently become the key services traded internationally. Countries such as the US, the UK, Australia and India are leading countries exporting educational services. Universities in these countries have established subsidiaries in developing countries such as in Sri Lanka to meet the local demand for international educational services. Even countries such as Malaysia have entered the export market of educational services and it now has an estimated annual foreign student population of nearly 50,000 following various educational programs.

Sri Lanka has failed to capture the rising trend in international trade in services. Even in the case of soft ware development, the country’s contribution is negligible while other countries have done extremely well. For example software trade of India has increased from US $ 500 million in the mid 1990’s to US $ 16 billion in 2003. India is also a leading country for exports of health services including Ayurvedic treatment. Sri Lanka has failed in this activity as well. Furthermore, export earnings from non traditional services such as telecommunication, information technology, insurance and business total only about US$ 400 million per year at present. While this amount is relatively small, the net income i.e., exports minus imports, is still either negative or marginally positive which suggests that the country has not made any progress in cross border trade in non traditional services despite the growth in the services sector.

The Services sector in the Sri Lankan context is dependent on spending by domestic consumers. The rapid growth in money supply, which usually remains around three times the economic growth rate, is also a contributory factor underlying the growth in the services sector. The excess supply of money appears to end up in the hands of the consumer which in turn boost the demand for various services leading to growth in these services. In this context, even the long term sustainability of a faster growth in the services sector appears not very promising unless the average incomes of the population significantly increase.

The writer is a freelance economic and financial consultant. He was formerly an Economic Specialist with the United States Agency for International Development (USAID), and a Lecturer in Financial Economics and Statistics at Victoria University, Australia. E mail: tilaks@slt.lk

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