After a lapse of over 35 years following the adoption of economic liberalisation, Sri Lanka is yet to reach high economic growth ranging above 8 per cent that could be sustained for several consecutive years. An annual Gross Domestic Product (GDP) growthrate of 8 per cent or more was achieved only on three occasions (1978, [...]

The Sundaytimes Sri Lanka

Sri Lanka not yet ready for knowledge-driven economic growth


After a lapse of over 35 years following the adoption of economic liberalisation, Sri Lanka is yet to reach high economic growth ranging above 8 per cent that could be sustained for several consecutive years. An annual Gross Domestic Product (GDP) growthrate of 8 per cent or more was achieved only on three occasions (1978, 2010 and 2011) throughout the post-liberaliisation period since 1977. Following the cessation of the prolonged conflict, GDP growth rate rose from 3.5 per cent in 2009 to 8.0 per cent in 2010 and to 8.2 per cent in 2011 due to increased availability of resources, productivity improvements and increased consumer demand. However, the growth momentum could not be sustained for long, and the growth rate remained low at 6.3 per cent in 2012 and 7.3 per cent in 2013 reflecting the normal trend.

GDP growth rate is projected at 7.8 per cent for this year, and it is targeted to rise beyond 8 per cent from 2015 onwards to reach 8.4 per cent by 2017, according to the government’s Medium-term Macroeconomic Framework. Achieving such high economic growth is a major challenge faced by the country in the midst of limited growth potential, minimal technological applications, dependence on labour-dependent exports and intense global competition. The country’s long-term growth potential remains around 6.75 per cent per annum, according to a recent working paper of the IMF (WP/14/40). This, of course, could not be considered as a rigid limit to growth, but a variable boundary depending on the changes in production efficiency, physical and human capital and knowledge inputs. Nevertheless, the low growth potential gives us an approximate indication about the challenges to be encountered in materializing the targeted high growth rates.

Changing growth paradigms

In the context of the knowledge-driven global economy manifested by fast developing technology and innovation, it is essential to have the necessary preconditions to realize the target growth rates for Sri Lanka given in the macroeconomic framework. In this regard, it might be useful to look at the country’s future economic growth scenario in the light of changing growth paradigms. The neoclassical growth theorists gave much emphasis to physical and human capital accumulation as the major sources of growth. In contrast, endogenous growth theorists champion knowledge, technological progress and productivity improvements as the key drivers of growth. Accordingly, technology and innovations based on research and development (R&D) are dominant determinants of a country’s economic growth. The question, therefore, is whether Sri Lanka has the necessary capabilities to make headway towards knowledge-driven economic growth.

First wave of growth perished

The country’s competitiveness in low-skilled and low-wage based industries gradually eroded over time due to wage increases and global competition. But the export sector has continued to depend heavily on labour-dependent industries, mainly garments.

Harnessing the benefits of the initial round of market-oriented economic reforms, Sri Lanka managed to graduate from the low income status to the lower-middle income status (according to the World Bank country classification) in 1998 – two decades after the liberalisation. In the 1980s, labour was the major source of the country’s economic growth, and thus, the economy was in a ‘factor-driven phase’ with growth contributions largely originated from low-skilled and low-cost labour and natural resource endowments. That could be identified as the “first wave of economic growth”.

Foreign trade and exchange liberalisation coupled with tax holidays and other incentives for investments helped to attract foreign investors to set up export-oriented industries. Low wages prevailed during that period made the economy more competitive for labour-intensive and low-tech manufacturing industries, mainly garment exports. It was a major factor that contributed to Foreign Direct Investment (FDI) inflows. The resulting increase in export earnings provided a major impetus to surge economic growth in the 1980s and 1990s. Sri Lanka also had the advantage of being a pioneering nation to launch economic liberalisation way back in the latter part of 1970s while many developing countries in Asia and other regions continued to follow closed economy regimes until around 1990s.

The country’s competitiveness in low-skilled and low-wage based industries gradually eroded over time due to domestic wage increases and global competition. Also, several developing countries such as India, China and Vietnam which adopted open economy policies much later had a competitive edge due to their low wages and other favourable factors. As a result, Sri Lanka lost her competitiveness in labour-intensive industries. In spite of this unfavourable trend, the export sector has continued to depend heavily on labour-dependent industries, mainly garments.

Inadequate technological progress

Having passed the factor-driven phase, the main source of economic growth of Sri Lanka has been efficiency or Total Factor Productivity (TFP). Thus the economy has been in the ‘efficiency-driven’ phase since the mid-1990s. Improved technological applications, among other things, have contributed to step up the productivity. Nevertheless, these technological improvements have not been sufficient enough to support a high GDP growth trajectory over a long period.

As noted above, the export sector has been continuing to rely on primary type of industries such as apparel industry. Apart from the policy drawbacks, this reflects the lack of innovative capabilities as well as poor commitment on the part of export-oriented companies to diversify their industrial structure with high-tech products. Foreign investors too did not show much interest in setting up such sophisticated industries. In contrast, many fast growing East Asian countries shifted to high-technology products since the 1970s when they lost comparative advantage in low-tech products such as garments.

Such product shift has not materialised in Sri Lanka due to inadequate technological progress. In the circumstances, high-tech exports account for only 0.9 per cent of total manufactured exports in Sri Lanka in 2012, compared with the corresponding ratio of 43.7 per cent for Malaysia, 26.2 per cent for South Korea, 26.3 per cent for China and 6.6 per cent for India.

Low R & D

A major constraint to promote technology and innovation in Sri Lanka is the dearth of funding available for research and development (R&D). The total expenditure for R&D remains low at less than 0.2 per cent of GDP in Sri Lanka in comparison with nearly per cent of GDP in South Korea, and over 2 per cent in Singapore. These countries made substantial economic progress through R&D to achieve knowledge-driven growth, and graduated to high-income country status. In Sri Lanka, the government contributes around 55 per cent of the total R& D expenditure, the private sector around 40 per cent and other agencies including foreign sources around 5 per cent. High priority needs to be given by both the government and the business sector to raise R&D investment in Sri Lanka from its present low levels.

Long way to escape the ‘middle income trap’

The concept of the ‘middle income trap’ means stagnation of a country’s per capita income in the middle income range over a prolonged period failing to graduate to the high income category. It is usually easier to climb from a low-income to a middle-income economy than to make a big jump to a high-income economy. The reason is that a poorer country can use the low living standards to her advantage. For example, wages in such a country are relatively low due to poor living standards. As stated above, low wage rates make the economy more competitive in labour-intensive basic manufacturing industries such as garments and leather products. As a result, factories begin to prosper creating employment and income generating opportunities. As incomes rise, however, production costs also tend to increase nullifying the earlier competitive advantage with respect to low-tech manufacturing industries. Thus, the initial wave of growth eventually runs out of steam. It happened in Sri Lanka since the 1990s, as explained earlier.

In consequence, a developing country may get trapped once it reaches a relatively comfortable middle range per capita income, and fails to climb to the next level – high income status. Several countries in the East Asian region (including Malaysia and Thailand) and in the Latin American region (including Argentina and Brazil) which had displayed high economic growth earlier are caught up in the middle income trap. Recognizing the need to address the middle income trap problem, the governments of Malaysia and Thailand have introduced entirely new economic policy strategies to uplift their growth paths. From among developing countries, only a few have been able to rise to the high income category after remaining in the middle income category for about 20 years. The frequently quoted examples are the four “Asian Tigers” – Hong Kong, Singapore, South Korea and Taiwan.

Escaping the middle income trap is not an easy task. It requires an entirely new growth model. The old style manufacturing industries dependent on cheap labour and foreign capital would not be sufficient to accelerate income growth. Labour and capital have to be used more productively, and in this context, creativity and innovation become critically important. An entirely new modus operandi of production process is needed. Companies must invest heavily in R&D to innovate high-tech products with their own brand names, instead of merely assembling foreign products using imported technology and foreign capital.

As Sri Lanka failed to effectively respond to the middle-income trap calamities, her growth performance after reaching the lower-middle income status has not been very impressive. While the prolonged ethnic conflict was a key factor responsible for the growth slowdown, several other detrimental factors including macroeconomic imbalances and policy inconsistencies have exerted adverse growth implications. As a result, Sri Lanka has remained as a lower-middle income economy for more than 15 years. It is projected that the country would reach the upper middle income status by 2015 when her per capita income reaches $ 4,243 as per official projections. The longer time period taken to make this progression is a disturbing concern from the viewpoint of its adverse consequences on socioeconomic development. Sri Lanka is likely to remain in the middle income category for a much longer period in the coming decades as the per capita income will have to reach as much as $12,616 (in current dollar terms), if she is to move to the high income category.

Sri Lanka’s knowledge economy ranking unimpressive

It is evident from the successful countries in East Asia, particularly South Korea, that structural economic shifts outlined above could be achieved only by transforming the economy into a knowledge economy. A knowledge economy is one that creates, disseinates and uses knowledge to enhance its growth and development. Such an economy is characterised by high value added products containing high knowledge inputs. Knowledge intensive activities could expand across diverse fields including R&D, scientific work, information services, ICT, legal and accounting services, architecture, engineering and consultancy. According to the World Bank, a knowledge economy requires four pillars, namely (a) business environment, (b) dynamic information infrastructure, (c) human resources, and (d) efficient innovation system.

A country’s position with regard to knowledge advancement could be assessed by the Knowledge Indices compiled by the World Bank. There are two types of knowledge indices: (a) Knowledge Index (KI) which is a composite of three sub-indices covering education, innovation and ICT, and (b) Knowledge Economy Index (KEI) which combines KI and the sub-index for economic and institution regime encompassing tariff and non-tariff barriers, regulatory quality and rule of law.

Sri Lanka’s position in the country ranking of a knowledge economy is not very satisfactory. She is placed at the 101st position out of 142 countries in the ranking for the year 2012.

In the performance score schedule ranging from 0 (=lowest) to 10 (=highest), the KI for Sri Lanka is only 3.63 as against 8.52 for Hong Kong and 7.97 for South Korea. Meanwhile, the KEI score for Sri Lanka is only 3.49 whereas the scores for South Korea and Hong Kong are 8.65 and 8.17, respectively. These wide divergences imply that Sri Lanka has to make substantial progress to evolve a modern knowledge-based economy.

Macroeconomic imbalances

Macroeconomic stability is an essential element to pave the way to a knowledge-driven economy. A major growth constraint encountered by the country is the continuous deficits in the government budget and foreign trade account. Given the intimate relationship between these two deficits and their interactive repercussions on the entire economy, they are known as ‘twin deficits’ in economic literature. Fiscal consolidation is critically important to avoid the adverse consequences of budget deficits and public debt accumulation on money supply, inflation, interest rates, balance of payments, investment and savings.

Fiscal deficits have led to an accumulation of public debt causing severe debt servicing pressure on the budget year after year. Government borrowings from the domestic market have led to preempt resources from the private sector, and to widen the gap beween savings and investment. The borrowings have also had distortionary effects on market interest rates. As noted earlier, the continuous dependence on a few labour-dependent basic industries has prevented any dynamic growth in the export sector, and led to widen the foreign trade deficits. The persistent budget and foreign trade deficits have not only constrained economic growth, but also disturbed economic stability of the country.

Less corruption, rule of law needed

Targeting GDP growth for future years over and above the potential growth rate would be an overambitious exercise, unless effective actions are taken to expand the growth frontier.

Targeting GDP growth for future years over and above the potential growth rate would be an overambitious exercise, unless effective actions are taken to expand the growth frontier. As explained above, technology and innovations based on R&D is an effective way to expand the potential output. However, it would be rather impossible to achieve such output growth in the short or medium run due to the gestation periods between R&D and output effects. The gestation period may be two to three years or more. According to some preliminary estimates carried out by me based on limited data, R&D elasticity of GDP is around 0.3 for Sri Lanka. This means that 1.0 per cent increase in R&D might lead to a 0.3 per cent increase in GDP with a lag of about three years.

Investment in R&D alone is inadequate to shift the country towards a knowledge economy. Other prerequisites should also be in place for the purpose. Specifically, economic stability – low inflation, fiscal consolidation, low public debt and strong foreign exchange position – should be sustained by robust macroeconomic policies. Business environment should be conducive to efficient creation, dissemination, and use of existing knowledge. In this regard, ensuring business confidence through corruption-free political and administrative systems, rule of law, intellectual property rights and good governance are crucial. They are essential to attract foreign direct investment as well. Targeting over-enthusiastic GDP growth rates without giving adequate emphasis to these ground realities is meaningless.

(The writer is a former central banker, university academic and researcher at the University of California, Irvine, USA. This article is based on a public lecture delivered at the National Science Foundation recently.)

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