Columns - The Sunday Times Economic Analysis

Investment key to economic growth

By the Economist

Investment is the key determinant of economic growth. This is one fundamental economic principle that is never flouted. Whatever the economic system and policies are this iron law of economics prevails. However investment itself is determined by many conditions and factors that are not only economic.

The rate at which an economy grows is also determined by factors that affect the efficiency of the capital employed. Most of these are fairly stable over the short term and can be altered only over the medium and long run. Therefore the rate of growth of an economy is determined by the rate of investment and the level of efficiency of capital. Non economic factors affect these two variables for economic growth. That is why it is inadequate to look at the economic variables alone to account for the level of achievement of an economy.

The Sri Lankan vision of attaining an 8 per cent growth rate is dependent on whether the country is able to mobilise adequate savings for investment. At the current rate of efficiency of capital the economy requires to invest about 40 per cent of GDP to achieve a sustained 8 per cent growth. This is a far cry from the savings and investment levels achieved in the recent past. Over a long period of time investment has been around 25 per cent of GDP.

In 2009 the country invested only 24.5 per cent of GDP. Domestic savings were only 18 per cent of GDP. The low growth rate for 2009 of 3.5 per cent was also due to other global and local conditions that affected the economy. For the same reasons the economy is likely to grow at a higher rate in 2010, due to favourable conditions. The end of the war brought about a revival of several sectors of the economy, especially fisheries, agriculture, tourism and ancillary economic activities and construction.

Besides this the low economic growth rate itself in 2009 makes it easier to achieve a higher rate in statistical terms.

Achieving a sustained high growth rate is a different proposition. In the next five years the growth of the economy would be very much dependent on the level of investment. This must rise to around 40 per cent of GDP. Much of this increase must come from domestic savings. With a current domestic savings ratio of only 18 per cent increasing this to at least 25 per cent is a gargantuan task. If the efficiency of capital could be improved to an incremental capital out ratio of 4:1 then an economic growth of over 8 per cent is possible with the current rate of investment.

A sudden improvement in the efficiency of capital and an increase of investment is not realistic. Therefore there has to be a greater reliance on foreign investment and foreign borrowing in the short term.

Unfortunately indications are that there has been a decrease in foreign investment this year. Foreign borrowing on the other hand has increased. However, much of this foreign investment is on infrastructure development that would contribute to growth in the long run rather than in the next few years. Besides there is a question of whether some of the large investments in infrastructure is on an economic priority basis that would yield high returns to investment.

What is needed immediately is an increase in foreign direct investments in industry and services. The advantage of foreign direct investment is that it has no cost to the country. Besides this, most foreign investors would bring a capacity to market their goods abroad. The scientific, technological and managerial skills they bring would in the fullness of time be transferred to Sri Lankans and this transfer of technology would enhance the economic growth capacity in the long run. The contribution of foreign capital for development cannot be measured in terms of the amount of finance capital alone.

Foreign investments in the stock market are quite different. These are short term capital for the most part and investors are ready to make a profit and leave the market as soon as it is to their gain. In fact a booming stock market as we see today and have had for sometime now may be a drain on foreign reserves rather than a benefit. What is needed is an attraction of industries that have a reasonably high local value addition and employment of the labour force and would in the process of their activities transfer technology and management skills of permanent value.

In order to both promote domestic savings and investment and attract foreign investment it is vital that investors have confidence in the country’s economic fundamentals. The containment of the fiscal deficit to manageable proportions, reduction of the debt and debt servicing costs, curtailment of huge losses in public enterprises and an image of a country seriously resolved to usher in economic development are important.

Non-economic factors such as the rule of law, flexible labour regulations, guarantees of property rights, certainty in policies and improvements in economic and social infrastructure are vital to achieve a higher trajectory of economic growth. The potential to grow is now there with the end of the war and terrorism, but it can be realized only if these other conditions are achieved.

The economy would grow at 5 per cent without any special efforts by the government. This is what we have been able to achieve in the past. The indisputable fact is that a 5 per cent growth will continue to keep a high proportion of people in poverty. Therefore it is vital that to achieve the higher growth rates that the government has stipulated as needed a wide range of conditions are created. There has to be conscious efforts to increases domestic savings through an economic environment that encourages higher levels of savings and investment. The lower rate of current inflation is one of the favourable factors. There has to be greater confidence that the government places a high priority on economic affairs rather than political diversions.

The rhetoric of achieving high levels of economic growth must be backed up by actions. The government must put its own finances in order and reduce the fiscal deficit. Taxation policies must be conducive to investment while at the same time effective in increasing revenues that are very low. Public enterprises must be run efficiently so as to ensure that they do not incur massive losses. Now that the war is over defence expenditure should be curtailed to levels consistent with peace time. All these prerequisites for growth and much more are needed to propel the economy to the much sought after 8 per cent sustained growth in GDP.

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