Sri Lanka’s rank on the World Bank’s well respected Ease of Doing Business Index (covering 185 economies) improved considerably over the last year. Vaulting from 96th in the world to 81st, an improvement of 15 places, is no mean feat. A back of the envelope calculation based on the World Bank’s ‘Does doing business matter for foreign direct investment?’ report indicates that these reforms should have led to an approximately US $ 1 billion increase in foreign direct investment (FDI). Sri Lanka’s FDI never reached US $ 1.8 billion -it fell over the two-year period from US $ 896 to US $ 813 million. One doesn’t require an economist to tell you this is odd and needs explanation.
Business Index: Looking under the hood
Composite indices, like the Doing Business Index, are strange animals. They are made of many constituent parts – in this case multiple sub-indices measuring particular aspects of the business environment. As in any composite system, in the Doing Business Index as well, some parts can be more critical than others. At least part of the answer to our mystery may be found by breaking the index up into its components and seeing what’s really going on under the surface.
In the lingo of business strategy, a Red Ocean business is one that is easy to enter but hard to survive. A keener look at the numbers disaggregated Business Index begs the question: Does Sri Lanka fit that description as a country? The underlying issue is a problem of long-term confidence.
Disaggregating the index, the picture is striking. Sri Lanka’s doing quite well on seven of the ten indicators that make the index, but is doing extremely poorly on three: Paying taxes, enforcing contracts and registering property. FDI depends as much on investor confidence as business ease. The three indicators Sri Lanka is ranks poorly on are those that directly affect long-term investor confidence.
Sri Lanka: Three dimensions of confidence problem
Enforcing contracts is fundamental to investor confidence. The enforcing contracts rank is determined by three variables, time, number of procedures and cost. Sri Lanka ranks 133rd in the world because it takes 1,319 days - almost four years - to enforce a contract. That’s almost three times the OECD average (the OECD is a club of rich countries) and nowhere near Singapore’s lightning fast 150 days.
Sri Lankan tax rates aren’t onerous - the primary cause for Sri Lanka ranking the lowest in South Asia and 175th out of 185 countries in the world is complexity. Sri Lanka can require 63 payments a year, which is double the South Asian average of 30. Leaving aside filing costs, the uncertainties that surround such an extensive array of tax regime compliance can give anyone reason to pause and reduces investor confidence.
Property registration is linked to the fundamental concern for the protection of property rights and is an important aspect of investor security. But in the property registration indicator Sri Lanka is also facing problems: Pakistan, India, Bhutan, Cambodia, the Congo, Rwanda and Ethiopia all rank well ahead of Sri Lanka. Despite reducing the time taken to register property by almost a month, businesses in Sri Lanka still have eight procedures to complete, compared to the South Asian average of six. This creates opportunities for corruption, stalling and increases uncertainty all contributing to higher risk and reduced confidence.
It is correct that local business magazine surveys are presently identifying the ‘Political Culture’ as the single largest concern for business confidence. But the Doing Business Index, which is what is analysed here, does not measure this dimension. But it could be reflected indirectly: Serious problems in contracts enforcement, tax systems and property rights are often connected to political culture.
Sri Lanka’s improvement in the composite index last year was spearheaded by a huge leap from 71st to 33rd place when it comes to starting a business (on the 2013 backward revised estimations). This is commendable. Registering property and access to credit improved too but unfortunately, other important indicators either improved marginally or even declined, such as investor protection.
This may explain some bits of the FDI puzzle. Starting a business is not one of the primary considerations affecting foreign investors, partly because the process is facilitated by intermediaries and also because they usually plan for the long term so the fixed cost of starting is negligible. Investor protection, enforcing contracts and paying taxes are certainly much more important – these are the indicators that usually come up in political risk maps and broader business environment indices.
Being good on average is not good enough
A meal with plenty of green vegetables but also butter and bacon may be aggregated as being healthy on average but the doctor is not going to approve.
Sri Lanka’s index suffers from this problem of having a very high variance amongst the component indicators. For investors who are rightly concerned with the overall consistency and stability of the business environment, it may not look like what the doctor ordered.
Another way of thinking about the problem is that the Sri Lankan investment climate may only be as healthy as its weakest links. The problems surrounding the paying of taxes, registering property and enforcing contracts are going to have the strongest influence on investor decisions. Without fixing these problems, attracting investors will require costly compensating concessions such as those currently being structured through the Strategic Development Projects Act.
The insight then is simple: The lack of reliable long term FDI is related to the problem of long-term confidence and the priority for policy is not to achieve improvements in the composite business index, nor to provide ad-hoc concessions but to make significant improvements in the three areas in which Sri Lanka is showing up at the tail end of the race.
(Verité Research provides strategic analysis and advice for governments and the private sector in Asia)