Workers at a Free Trade Zone garment factory
The fate of not just its economy but the very essence of Sri Lanka’s social fabric hangs in the balance. The violence of the week beginning on May 9th was created by
supporters of the now resigned Prime Minister, Mahinda Rajapaksa. At the time of writing, there has been no word from a beleaguered President Gotabaya Rajapaksa. Eventually, when there is once again a serious, working administration in place, the real work will have to begin.What economic policy direction Sri Lanka takes at that crucial juncture will depend on what kind of administration controls the levers and what type of coalition controls that administration. Which personalities will be in that room to guide policy decisions? This is a necessary discussion about the long-term direction of economic policy-making and the foundational principles and assumptions we rely on in setting the objectives of those policies.
The Gospel of Orthodoxy
Let us begin by introducing the argument against what is considered liberal economic policy orthodoxy, that which is espoused by multilateral agencies such as the IMF as well as many mainstream economists.
Prof. Ha-Joon Chang is a South Korean Economist attached to the University of Cambridge, specializing in development economics. Writing in 2003, Prof. Chang reiterates his challenge to the long-held assumption that “economic theory has irrefutably established the superiority of free trade”, pointing to the history of capitalism and how “virtually all of today’s developed countries did not practice free trade (and laissez-faire industrial policy as its domestic counterpart). Rather, they promoted their national industries through tariffs, subsidies, and other measures.”
In formulating its long-term policy, Sri Lanka must decide how it is to engage in the global free trade order. As Prof. Chang states “Debunking the myth of free trade from the historical perspective demonstrates that there is an urgent need for thoroughly re-thinking some key conventional wisdom in the debate on trade policy, and more broadly on globalization.”
The root of Sri Lanka’s economic distress has long been evident: our dependency on US Greenbacks; an incurable addiction to the Dollar. Whether it is Sri Lanka Development Bonds, Sovereign Bonds, bilateral loans, FDI, migrant worker remittances, rubber, tea or tourism, earning foreign exchange remains Sri Lanka’s over-riding policy challenge.
Every administration in recent memory has focused its rhetoric and policy on growing our export trade by diversifying and expanding in the various sectors such as Tea and Seafood. Mainstream economic doctrine suggests Sri Lanka should liberalize its economy and dissolve barriers to trade, fully engaging in the global economy. The introduction of competition will not only benefit Sri Lankan businesses, spurring them on to innovation, but will also benefit consumers. So far, so orthodox.
Despite various initiatives: investment road-shows, tax holidays, the explicit solicitation of ‘grey’ money; Sri Lanka still lags well behind the necessary level of foreign exchange earnings and thus relies on international finance flows, borrowing heavily to fund the state and its activities.
The Merry-go-round of Debt and Decadence
The current period bears a striking resemblance to Sri Lanka’s first post-independence economic policy debacle. A 1997 research paper by S. Kelegama and D. Dunham provides a brief overview of the state of Sri Lanka’s economy: “Prior to 1977, Sri Lanka’s economy was inward-looking. The state pursued an import-substitution strategy. There were quantitative restrictions on imports and stringent exchange controls. Public corporations were dominant in almost all sectors of the economy; the state was committed to heavy social expenditures and a bloated state sector was sustained by surpluses squeezed from plantation exports. There was an entrenched tradition of political patronage…” These are virtually the same set of policy inconsistencies visible in the Sri Lankan debacle of 2022.
Even in 1997, Kelegama’s description of the 1960s and ‘70s paints a familiar picture; “The country faced unsustainable budget deficits, a balance-of-payments crisis, and widespread hardship. Low growth, high unemployment, and the rationing and black marketing of essential goods nurtured disaffection.”
It seems clear that the Sri Lankan economy jumped on a merry-go-round somewhere in the late 1970s and simply took a joy-ride, fed by that lethal cocktail of debt and decadence. The ride has now come full circle. This is not supposed to illuminate short-comings of the ‘77 liberalization, only to assert that it was incomplete, much like the lesser-known but perhaps more influential “second wave” of liberalization of the late 1980s/ early 90s.
"Whether it is Sri Lanka Development Bonds, Sovereign Bonds, bilateral loans, FDI, migrant worker remittances, rubber, tea or tourism, earning foreign exchange remains Sri Lanka’s over-riding policy challenge"
The set of policies implemented in 1977 injected some much needed orthodoxy, renewing a focus on fiscal consolidation. Then, as now, the grand hope was that ‘liberalization’ would attract foreign investment. In today’s context, devaluation, trade liberalization, growing money supply and credit growth in formal sectors, targeting welfare and deregulating to reduce the ‘cost to consumer’; these policy prescriptions from the ‘70s are all back in vogue. Meanwhile the Sri Lankan economy will inevitably revert to a dependency on international finance to plug the gaps left by tourism, tea and migrant workers.
What can we learn from this recent set of economic policy decisions and overarching policy direction and when can this dynamic of dependency begin to change?
The second wave of liberalization began in the late 80s and led to the now crucial Sri Lankan garment industry, a significant contributor to industrialization during that period. It is noteworthy that President Ranasinghe Premadasa was instrumental in conceptualizing this ‘second wave’ and perhaps ironic that a young MP, one Ranil Wickremesinghe, was charged with leading the project as the Cabinet Minister for Industries, Science and Technology.
The idea to industrialize had existed long before, you will notice it in the ‘Scheme of Industrialization Act’ which was passed in the late 1950s along with the ‘State Industrial Corporation Act’ which set up what would become state-owned enterprises (SOEs). The issue was that these acts entrenched essential industries in the hands of the state, a state that had only just recently spawned and was managing multiple societal and cultural shifts. The political climate would prevent the accommodation of private sector expertise and Sri Lanka’s industrial planning would be woefully under-developed.
The Vietnamese Experience
Sri Lankan-Dutch Economist Dr. Howard Nicholas, who has been teaching at renowned institutions for over three decades, has crucial insights within the Sri Lankan context, given his experience working in Sri Lanka and helping to set up the Institute of Policy Studies. During a recent interview, Dr. Nicholas confessed to his pessimism over Sri Lanka’s state in the late 1980s and early 90s; two wars, lockdowns, power cuts, restriction of movement; yet he also noted his amazement at what he called an “incredible transformation” that took place in Sri Lanka during that period.
Referring to Kelegama’s “second wave” of liberalization, Dr. Nicholas restates that “investors want to see the profits, they want to see profitable industrial activity, which is export oriented because there are then, no limits to the growth”. Dr. Nicholas makes the point that investors, especially those that operate in Asia, are well aware of the policy markers of progress from the Asian Tiger growth stories. In studying the Asian Tigers, Dr. Nicholas notes the inherent dynamism that is cultivated through a process of industrialization which “pivots a country to a different level; with very rapid phases of growth, of diversification of the production base and of increases in per capita income levels”.
"Mainstream economic doctrine suggests Sri Lanka should liberalize its economy and dissolve barriers to trade, fully engaging in the global economy"
The very recent experience of Vietnam, with its own industrialization fueled economic boom, might lend many valuable lessons for Sri Lanka. Dr. Nicholas was involved in the policy formulations in Vietnam and has noted that its industrial policy was an “all hands on deck” experience, with every aspect of the state focused on a rapid yet smooth transition to a manufacturing based economy. The transformation meant that Vietnam’s industrial base was agile enough to meet growing consumer demands created by the pandemic in 2020. Dr. Nicholas specifically notes the demand for home office equipment and how Vietnam’s capabilities and the range of its industrial base allowed it to make the switch seamlessly. Vietnam’s foreign exchange reserves reached a record USD 95 Bn in 2021, up USD 16 Bn over the previous year, in the midst of a pandemic.
Prof. Chang joins a growing number of economists that view free market doctrine with suspicion. A paper from 2008, during his time at Cambridge University notes the binary characterizations of “good policies” espoused by development orthodoxy of the time. “It has argued for, among other things, free trade, deregulation of foreign investment (FDI), privatization of state-owned enterprises (SOEs), and strong protection of intellectual property rights (IPRs), as key policies that are needed for developing countries to grow and develop their economies. In the promotion of these ‘good policies’ by the orthodoxy, the history of today’s rich countries has played an important rhetorical role. It is explicitly and implicitly suggested that those countries have become rich only because they followed those ‘good’ policies – the implication being that countries trying to do it in a different way is bound to fail, as it is more or less going against the ‘law of nature’. The awkward examples of the East Asian countries (such as Japan, South Korea, and Taiwan), which used protectionism, restrictions on FDI and other ‘bad’ policies, are brushed away as ‘exceptions that prove the rule’.”
Policies of Good and Evil
Throughout his writing, including the seminal ‘Kicking Away the Ladder’ (2002), Prof. Chang argues that the success of rich countries stems not specifically from policies of economic orthodoxy but from quite the opposite. This constitutes what Chang refers to as the ‘real’ economic history, contrasted with what is considered the ‘official’ history.
Chang argues: “Not just countries like Japan and Korea, whose trade protectionism is well known, but all of today’s rich countries have used protectionism for substantial periods… In particular, it is important to note that, contrary to conventional wisdom, Britain and the US – the supposed homes of free trade – were in fact the most protectionist economies in the world in their respective catching-up periods.”
For Sri Lanka, there are no easy answers; for industrial policy to succeed, there will need to be hard choices made on what industries the state should support and which have to be cut off from their dependency on the Government. Protectionism cannot also become perpetual, time-lines must be agreed and for long-term success, some aspects of industrial policy will need to be legally assured of continuity. There is a complex balancing act between attracting competition so that local industry may benefit from it while absorbing and improvising their technological advancements versus allowing foreign firms to cannibalize smaller local companies.
Chang contends that many economic success stories of the modern age were well-orchestrated by purpose-built institutions within the state. “Many of today’s rich countries regulated FDI when they were on the receiving end – the US, Japan, Finland, Korea, Taiwan are particularly striking examples. In the 19th century, the US banned or heavily regulated FDI in natural resource exploitation (such as mining and logging), coastal shipping, and finance (banking and insurance) – sectors where FDI were concentrated at the time. In national (as opposed to state-level) banks, foreigners could not become directors and foreign shareholders were not even allowed to vote in shareholder meetings. Japan, and to a lesser extent Korea and Taiwan, more or less banned foreign direct investment in key sectors and heavily regulated them in other sectors until the 1980s. Finland also had draconian regulation of FDI until the 1980s.”
“Free trade, deregulation of foreign investment (FDI), privatization of state-owned enterprises (SOEs), and strong protection of intellectual property rights (IPRs), are key policies that are needed for developing countries to grow and develop their economies"
Sri Lanka’s development strategy must urgently focus itself on industrial policy, becoming supportive of industry rather than an obstacle to the process. Industrialization must coincide with investments in various forms of infrastructure including technological for eg: high speed internet access for rural villages at a lower cost, subsidized by the government. The rewards of connecting more students to the learning ‘grid’ can only be a positive for the nation’s human resource development.
Industrial policy by definition will have many constraints, not least from external influences such as multilateral organizations espousing Chang’s “good policies”. The intervention that industrial policy requires in trade policy alone brings it into conflict with those ‘free market’ principles that are supposed to underpin the Sri Lankan recovery. Policymakers must urgently distinguish between building a Sri Lankan economy to survive global economic headwinds versus equipping it to thrive in the global market. Both are crucial but the latter entails a shift in thinking that will require both the market and the state to get along for the sake of the nation’s long term success.
Twitter: @kusumw
