Recent discussions on the trade balance and external finances have been mostly in terms of current developments and emerging problems. More important than the yearly fluctuations in the trade balance and changes in the annual reserve positions are the structural weaknesses in the economy that are the underlying causes for the country’s persistent problems in external [...]


Structural weakness in trade and external finances


Recent discussions on the trade balance and external finances have been mostly in terms of current developments and emerging problems. More important than the yearly fluctuations in the trade balance and changes in the annual reserve positions are the structural weaknesses in the economy that are the underlying causes for the country’s persistent problems in external trade and finances. Corrective actions to change these structural weaknesses are the manner to resolve the problems in the long run.

Sri Lanka’s external trade has always been vulnerable to international fluctuations in prices of both exports and imports and deterioration in the terms of trade. Structural weaknesses, though somewhat different over time, have been inherent from the time of independence, even though the country enjoyed some good years owing to a commodity boom soon after independence, when especially rubber prices soared.

The external trade and finance statistics for the past two years and in the first half of this year disclose the structural weaknesses in the country’s external finances. Imports are twice exports and a massive trade deficit is the result. The last two years witnessed trade deficits of US$ 9.7 and US$ 9.3 billion and indications are that this year’s deficit too would be around US$ 9 billion.

Persistent trade deficits
Not surprisingly, due to structural weaknesses in the export and import structure, the country has had very few years of trade surpluses. The last trade surplus was thirty six years ago in 1977, when a small trade surplus was achieved through stringent import controls and exchange restrictions. Although the economy grew rapidly after liberalisation, and there was significant diversification of the economy, the trade account has been in deficit. The country exchanged its dependence on a few agricultural exports to one dependent on narrow low-tech exports that were dependent on imported raw materials and intermediate goods. These exports were highly competitive in global markets. Dependency on oil imports was another cause of instability.

On the other hand, the import structure remained inelastic with essential imports accounting for a high share of imports. Increased per capita incomes and increased capital expenditure were sources of large imports for consumption and investment. As much as one quarter of imports were for oil whose prices are volatile. The high propensity to import characteristic of small resource poor countries is the fundamental cause for external vulnerability.

Workers’ remittances
The saving grace has been the large volume of workers’ remittances that have been adequate to offset a high proportion of the trade deficit. In the post war years the resurgence of tourism and growing increases in tourist earnings have been the other factor that has helped avert a crisis in external finances. Nevertheless even these two were unable to bridge the deficit significantly in 2011 and a balance of payments crisis emerged. The increase in workers’ remittances and tourist earnings are likely to offset about 85 per cent of the large trade deficit this year and thereby ease the balance of payments.

These two developments could themselves result in policy complacency that avoids necessary actions to improve the structure of external trade. There has to be positive policy measures to reduce import expenditure, as well as increase exports substantially, rather than rely on remittances and tourism to bridge the trade gap. If the trade deficit could be brought down to more manageable proportions, then these earnings could be utilised to strengthen the country’s foreign reserves as well as reduce her foreign indebtedness.

A trade balance where imports are twice that of exports, or stated differently, exports are about one half of imports, is a clear indicator of where the problems lie. They lie in both the excessive amount of imports and inadequate earnings from exports. Therefore a two pronged attack of decreasing imports and increasing exports is required.

Import substitution
The usual response to this problem is that there should be more import substitution. While this is a reasonable response, there are limits to such a strategy, as there are no import substitutes for most of the key imports such as oil that constitutes more than 25 percent of imports. Fertilizer and textiles are also two such significant imports for which there are no effective substitutes.

There is some possibility of increasing food production, but there are constraints that make such a strategy of limited scope. In any event, food imports constitute only 11 per cent of import expenditure. There are possibilities of reducing imports if we reduce domestic consumption. Public expenditure that has high import content should be pruned down to achieve a reduction of imports. One of the fundamental reasons for the high import expenditure is the large government expenditure on capital intensive investment projects that do not earn foreign exchange nor save imports significantly. An effort must be made to pace these investments, as well as choose projects that make a positive contribution to export earnings.

Import expenditure
In the current situation that has been brought about by massive increases in imports, attention must be focused on how import expenditure could be reduced. This is indeed a difficult task as most imports fall into the category of essential either for consumption purposes or for the country’s production. Yet import expenditure that is twice that of export earnings is unsustainable and must be addressed.

In the category of consumer import expenditure much attention has been focused on food imports. However, total food imports constituted only 11 per cent of import expenditure. Nevertheless there must to efforts to reduce the food import bill. Rice is no longer of consequence but wheat imports account for about 40 per cent of food imports and about 5 per cent of import expenditure. Since wheat is not grown in the country and is an important item of consumption especially in urban areas and the estates, the extent to which wheat imports could be curtailed is limited. Besides increased tariffs on wheat means that it would affect the costs of living of poorer sections of the population. Wheat is also needed for the manufacture of confectionary products and bread. The effective means of reducing wheat imports is by greater substitution of rice for wheat both for direct consumption and as substitutes in the preparation of foods.

There has been much progress in domestic milk production though local milk production meets only about 30 per cent of the country’s needs. There are several least cost methods by which milk production could be increased in the short run. These must be explored to the full. Sugar production has been a miserable failure. Despite tariff incentives, sugar production meets less than 15 per cent of the country’s requirements. Government taking greater control of sugar cultivation is a step in the wrong direction as past experience demonstrates very clearly.

Export growth
Export growth is the most important strategy for improving the trade balance. There has been a significant diversification of exports in rubber manufactures electrical appliances, and even food and medicines. Despite the diversification of exports, these are inadequate to cope with the ever increasing imports.
The share of exports in GDP has fallen and the country’s share of global trade has declined. There is therefore a need to enhance exports by becoming more competitive, increasing exportable surpluses, especially in spice exports and new agricultural commodities.

Industrial diversification is an important strategy and could be achieved if the investment climate is improved and there are more foreign direct investments in industrial export manufacture. The expansion of exports of services that are high value addition exports, such as information technology, could make a vital breakthrough in enhancing exports. The external finances can be improved in the long run by a diversification into high tech products and services. Providing an investment climate for these is essential to achieve this.

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