Sri Lanka*

Sirimal Abeyratne Chandra Rodrigo

I. Introduction
The growth experience of Sri Lanka over the latter half of the twentieth century is a source of controversy. The achievements seem to be classified as good or bad depending on the comparisons undertaken, the aspects included in, or excluded from the analyses, and the perceptions of the analysts themselves. The controversy has been further heightened by the fact that the country was able to maintain high social development since the time of independence against its low per capita income. Given the mixed nature of the developmental achievements, it is not surprising that differences in opinion over the Sri Lankan growth experience continue to persist in the literature. The issue whether Sri Lanka, which grew at around 4% per annum during 19502000, has performed well or not, necessarily draws attention to cross-country and periodic comparisons. It has been a typical practice in analyses, when the average growth performance and the current economic position of the country are reviewed, to refer to the initial advantageous position of the Sri Lankan economy and the economic performance in other Asian countries at comparable stages. Particularly, the success stories of the newly industrialized countries (NICs) and the latecomers in East and Southeast Asia, which started off their growth process at comparable or even lower levels of economic positions in the mid-twentieth century, indicate a clear backwardness in the growth performance of Sri Lanka. Although the point is very valid, a counter argument is that the East Asian success is a special case, much deviated from the growth performance of most of todays industrialized and developing countries. Compared to the general growth patterns of the world, the Sri Lankan growth performance over the past five decades does not appear to be backward in nature. Moreover, the economy has grown, though moderately, in the midst of worsening balance of payments, declining terms of trade, aggravating fiscal burden and even escalating political unrest and civil wars of the country. The initial conditions of Sri Lanka in terms economic, social and political factors indicated at the time of independence that the countrys developmental achievements were already greater than most of the Asian countries, and that it would be a first potential case of development success among the newly independent nations. Given the initial advantageous position of the country, it is difficult to reject the idea that the countrys growth performance lagged far behind its developmental expectations and growth potentials. The growth performance also lagged behind the standards required to sustain the welfare democracy itself, since growth constituted the very foundation
*

This chapter is based on the original GRP study of the authors entitled Explaining Growth Performance in Sri Lanka: Fifty Years in Retrospect 1950-2000, South Asian Network of Economic Research Institutes (SANEI), New Delhi, 2000. The source of data in the chapter, unless otherwise specified, is this original GRP study. Authors wish to thank the resource persons and discussants of the GRP study as well as others for their valuable contributions and assistance.

necessary for the sustainability of the system. In addition, aggravated macroeconomic problems related to internal and external balance owed much to the inadequate growth performance itself. Furthermore, political unrest and civil wars were the products of the political economy of the countrys own development process rather than of some external force that disrupted the normalcy of the growth process. There are a number of major growth puzzles emerging from the following key issues related to the historical growth performance of Sri Lanka. In the first place, the country failed to take advantage of its unique and favourable initial conditions to yield a higher growth momentum. Secondly, in an increasingly restrictive trade regime prevalent until 1977, the economy gradually entered into a deep and continued economic stagnancy. Thirdly, even though Sri Lanka has been able to maintain a moderate growth performance in its post-1977 liberalized trade regime, whether or not trade liberalization for over two decades has ensured the conditions for sustainable growth and stability appears to be a point of controversy. Why did Sri Lanka miss the opportunities it had in order to exploit the favourable initial conditions to achieve growth momentum? Why did it continue for decades with import substitution in an increasingly controlled trade regime, even when the growth performance had proven to be disappointing? Why did trade liberalization delay in establishing the conditions for sustainable growth and macroeconomic stability? How did the policy and institutional factors contribute positively or negatively to contemporary growth performance? What factors contributed to the choice of a particular policy in a given period of time? What is the policy and institutional outlook at the turn of the century in terms of achieving and sustaining rapid growth? What are the lessons that the historical experience has provided in guiding the reform process and, in this respect what are the challenges faced by policy makers? This study probes these questions with the prime objective of explaining economic growth and related macroeconomic performances over the period of the past 50 years. It seeks to highlight the major policy and institutional factors that have contributed to the different patterns of growth performance in different periods of time, enabling policy lessons to be derived. The growth puzzles are explored by analyzing the growth responses to the policy regimes and the variations in policies within the regimes. The shift in policy regimes and the variations within policy regimes are closely associated with political changes throughout the post-independence history of the country. A study on growth response to the policy regimes, therefore, involves a greater degree of attention on the institutional factors within the political economy of the country that constituted the choice of policies and conditioned the growth outcome. In this respect, it is necessary to acknowledge the perceptions and expectations of the policy makers as well as the surrounding environment in which these policy makers acted. The rest of the analysis is organized in four sections. An overview of economic performance throughout the past five decades with the initial conditions is presented in the second section. An analysis on the changes in policy regimes and policy responses is undertaken in the third section. In the fourth section, the major growth puzzles emerging from the growth experience of the country are examined. In the final section, the conclusions of the study are presented with policy lessons and challenges in achieving sustainable growth.

Sri Lanka

II. Initial Conditions and Economic Performance

Sri Lanka is a small island on the Indian Ocean with a land area of 65 thousand square kilometers. The country is home to a multi-ethnic and multi-religious community of around 19 million at present. The arrival of Western sea-faring powers in the Indian Ocean in the early sixteenth century marked a turning point in the countrys history. About four and a half centuries of colonial rule, successively under the Portuguese (15051658), the Dutch (1658-1796) and finally the British (1796-1948) transformed Sri Lanka into an exchange economy integrated into the international market at an early stage of its economic evolution. At the time of gaining political independence from Britain in 1948, Sri Lanka provided a classic example of a dualistic export economy, which comprised an exportoriented modern plantation economy and a traditional subsistence-oriented agricultural economy (Snodgrass 1966). The plantation agriculture comprising tea, rubber and coconut, which together came to be known as the traditional export crops,1 had transformed Sri Lanka into one integrated with the world trade network. At the time of independence, according to the estimates of Snodgrass (1966), this sector accounted for about 35% of GDP, 85% of export earnings and 30% of employment in Sri Lanka. It also initiated and sustained a range of other ancillary service activities in the economy such as transport, communication, commerce and banking. Servicing the plantation economy was a network of roads and railways and communications connecting the hinterland with the centre and, transport and harbour facilities linking the economy with the outside world, all developed under British rule. Apart from export processing activities related to plantation agriculture, the manufacturing sector comprised a few state-owned industrial ventures for import substitution. Virtually, there was no export-oriented manufacturing production. The existing industrial ventures that produced, for instance plywood, acetic acid, drugs, ceramics, glass, paper, steel, leather and textile, had emerged during the Second World War, in response to the disruption of the flow of imports of the relevant commodities. The war-generated spurt in manufacturing activities, which were thought to be successful industrial ventures due to their high profitability at the time, did not however, last long (Oliver 1957). With the return of the supply of imports to normalcy after the war, they began to reflect numerous operational problems, which led the government to close down some of the activities. The modem sector, however, constituted only a small segment of the economy. While capitalist forms of organization prevailed in a few key areas related largely to the plantation sector, the bulk of the economy remained pre-capitalist with its concentration on food crop cultivation, feudal relationships and limited exchange interactions. However, the colonial pattern of development had resulted in a heavy dependence on imported rice (the staple food) and many other essential foodstuffs to feed the population. Sri Lanka was perhaps the only purely agricultural country in the world that was not producing even half of its staple food at the time. As domestic agriculture, including
1

Plantations of tea and rubber started since the latter half of the nineteenth century. Coconut has been a traditional crop in Sri Lanka, known from ancient times, though its plantation form also emerged in the British colonial period. 3

Sri Lanka

paddy, did not attracted capitalist investment, the supplies were procured from abroad using export proceeds from plantation crops.

Initial Advantage
Economic prosperity Although Sri Lanka shared much of its initial conditions in common with most of the primary-exporting and low-income countries, it also had some distinguishing and even unique features. An important feature of the Sri Lankan economy at the time of its independence was its relatively favourable economic status. The economy, inherited from the colonial past, was much more prosperous compared to most of Sri Lankas Asian neighbours. The World Bank mission that visited Sri Lanka in 1951 attributed the prosperity to the revolutionary expansion of the plantation economy since the late nineteenth century (IBRD 1953). It appears to have improved further in the first half of the 1950s due to random, but temporary price booms in the international market favouring the countrys primary exports. In particular, the Korean war of 1950-51 and the tea price hike of 1954-55 resulted in a significant improvement in terms of trade and foreign exchange reserves and produced short-lived booms in the domestic economy. Although its rapidly growing population has trebled during the past 75 years until the mid-twentieth century, the living standards of Sri Lanka have been maintained and certainly enhanced in bringing the country to one of the highest positions among the neighbouring Asian countries (IBRD 1953: 1). Sri Lankas national income per head is, up till now, one of the highest in Asia (Robinson 1959: 40). The contemporary economic prosperity was also seen in terms of the favourable balance of payments position, strong external reserve level, sound fiscal operations as well as the high human development standards. The latter can be attributed to the early initiation of an extensive welfare system in Sri Lanka by channeling a significant proportion of the high income of the country into the improvement of living standards of the population. Extensive welfare system Sri Lanka has often been cited as a successful and exceptional case of adopting a direct approach to development through redistributive policies, in contrast to a strategy of achieving higher economic growth first before delivering its benefits to the masses. Whatever the validity of this argument, the country was able to produce a higher social development record despite its slow growth of per capita income. Even at the time of independence, along with the initial economic prosperity, the countrys achievements in terms of consumption, health and education were excellent (Robinson 1959). As the Socio-economic Survey of the Ministry of Finance of the first post-independence government reports, Sri Lankas record on social welfare, which impressed most of the financial observers from abroad, stands out in distinct contrast to other countries in South East Asia (Ministry of Finance 1951: 14). Among a wide range of the social welfare measures, the major programmes included free health care (both curative and preventive), free education from primary to university levels (including meals, textbooks, uniforms and scholarships), and state subsidies on staple food items and other essential goods and services. Thus, free health care, free education

Sri Lanka

and consumer subsidies became the major components of the states overall welfare package, among many other things. Democratic political system Unlike in some other ex-colonies, the transfer of power in Sri Lanka was gradual and peaceful. The last stages of the colonial rule saw a substantial measure of self-rule extended to the colony.2 It was under this arrangement of governance that the welfare tradition was entrenched in state policy even prior to political independence in 1948. The political system inherited by Sri Lanka from its colonial past was a Westminster-type democracy, as in some South Asian countries. It was characterized by a multi-party system of governance subject to regular general elections to select the government and a high degree of popular political participation (Jupp 1978, Kearney 1973, Wilson 1979). Two dominant political parties, which were the centre-right United National Party (UNP) and the centre-left Sri Lanka Freedom Party (SLFP), held power alternatively at regular general elections. There were other minor political parties based mainly on either the factions of leftist ideology or those of ethnocentric interests, of which the role was influential in the decision-making process of the country. In addition, the quasi-political organizations and power groups, including the trade unions, which were based on different ideological positions and backed by direct political parties, also played an important role in the decision-making process of the country. The leftists had already begun organizing the working class of the plantation and urban sectors (in the absence of an industrial sector) as early as the beginning of the twentieth century (Jayawardena 1985). The ethno-centric divisions in politics had also paved the way for differences in interests among ethnic groups. Sri Lanka had an extensive framework of protective labour legislation dating from colonial times regulating employee welfare and labour relations (Rodrigo 1988). The impetus for the expansion of the social welfare system and the formation of labour laws of a social democratic orientation even prior to independence came into effect as a conscious response to the political competition.

Sri Lanka in an Asian Perspective

The Sri Lankan economy, thanks to the favourable initial conditions conducive to the achievement of growth momentum, promised to be a best bet in Asia. However, the subsequent period of decades to come were marked by undistinguished economic performance among the developing countries in Asia and backward performance among the high-performing economies in Asia. This is confirmed by a comparison of the growth performance of Sri Lanka with not only that of the high-performing economies in East and Southeast Asia, but also with that of the South Asian neighbouring countries.

Sri Lankans had already begun to acquire decision-making powers in the State Council since the early eighteenth century. In 1910, a limited number of Sri Lankan were elected to the State Council, though the majority there were British members. In 1921, members elected by the Sri Lankans plus appointees outnumbered British members, while in 1924 elected members alone were the majority. With constitutional reforms under the Donoughmore Commission in 1931, Sri Lankans obtained near complete self-rule, including universal suffrage and an Executive Committee system under which the elected members wielded both legislative and executive power (De Silva 1981, Oliver 1957). Sri Lanka 5

Table 1 Sri Lanka in an Asian Perspective: Per capita GNP relative to USA (%) 1955 1960 1970 1980 1995 Sri Lanka 12.5 12.5 9.3 10.4 13.1 India 6.5 7.4 6.0 5.7 8.2 Pakistan 6.2 6.8 8.1 7.3 7.8 Indonesia ... 5.8 4.8 8.4 13.2 Thailand 7.4 9.6 11.9 14.3 27.0 Malaysia 14.2 15.0 15.8 25.8 37.8 Hong Kong ... 21.0 32.6 55.1 98.5 South Korea 8.9 8.7 12.8 19.8 48.9 Singapore ... 16.6 24.2 44.3 85.4 Taiwan ... 13.8 21.3 32.9 46.7
Note: ... Data not available. Source: National Bureau of Economic Research: Penn World Tables (web page), quoted in Athukorala (2001)

Table 1 shows the changes in per capita GNP in selected Asian countries relative to the USA. In 1955, Sri Lankas per capita income was greater than that of the other Asian countries listed in the table, except Malaysia.3 South Korea and Thailand continued to lag behind Sri Lanka in terms of per capita income even by 1960. A striking feature of the Sri Lankan economic performance is that its relative per capita income even in 1995 was not much different from what it had been 40 years ago in 1955. Even in this respect, much of the achievements in per capita income growth can be attributed tothe post-1977 liberalized trade regime. Prior to that, in the context of an increasingly restrictive trade regime, Sri Lanka had actually shown a significant deterioration in its relative per capita income, which had not been a common feature for many other countries listed in the Table. The per capita income of Sri Lanka has increased in absolute terms from US$ 152 to 255 during the period of 1960-80; the rate of increase was one of the lowest in Asia, lower than that of India and Pakistan (Abeyratne 2000: 23). Table 2 shows the changes in gross domestic savings and investment as a percentage of GDP among selected Asian countries. In 1960, with its moderate savings and investment ratios, Sri Lanka was not in an undistinguishable position among many Asian countries. In fact, Sri Lankas 9% of savings ratio and 14% of investment ratio in 1960 were greater than those of South Korea and Singapore, but lower than those of India and Thailand. The striking fact is the performance in savings and investment of the country over the subsequent decades, when compared to the other countries in Asia. The savings ratio has increased up to 14% of GDP by 1980 and remained at the same level even in 1995, thereby showing Sri Lanka as the country with the lowest savings ratio among those listed.

Malaysias higher per capita income in 1955 can be attributed to its more favourable land-population ratio than that of Sri Lanka. Malaysia, which had a large plantation sector, was 5 times bigger than Sri Lanka by land area, but it had a population of 8 million compared to almost 10 million in Sri Lanka at the time.

Sri Lanka

Table 2 Sri Lanka in an Asian Perspective: Saving and Investment as % of GDP Gross domestic saving Gross domestic investment 1960 1980 1995 1960 1980 1995 Sri Lanka 9 14 14 14 36 25 India 14 20 22 17 23 25 Pakistan 5 6 16 12 18 19 Indonesia 8 30 36 8 22 38 Thailand 14 22 36 16 27 43 Malaysia 27 32 37 14 29 41 Hong Kong 6 24 33 18 29 35 South Korea 1 23 36 11 31 37 Singapore -3 30 11 43 33
Note: Data not available Source: World Bank (annual issues): World Development Report

Table 3 Sri Lanka in an Asian Perspective: Export Growth (average annual % rate) 1960-70 1970-80 1980-90 1990-95 Sri Lanka 4.7 -2.4 6.3 17.0 India 3.0 3.7 7.0 4.5 Pakistan 8.2 1.2 8.8 2.1 Indonesia 4.0 8.7 21.3 1.2 Thailand 5.2 11.8 14.3 21.6 Malaysia 5.8 7.4 11.5 17.8 Hong Kong 12.7 9.4 15.4 15.3 South Korea 34.1 23.0 13.7 7.4 Singapore 4.2 12.0 12.2 16.2
Source: World Bank (annual issues): World Development Report

The investment ratio had increased up to 36% of GDP by 1980, and was the second largest among those of the countries listed in the Table. As we will discuss in the forthcoming analysis, this was a result of an abrupt rise in both public investment and foreign capital in the late 1970s. However, the country was unable to sustain an increased investment ratio, which declined to 25% of GDP by 1995. It was in line with those of the other South Asian countries, but remained much lower than those of Southeast and East Asian countries. Being one of the highly trade-dependent small economies in Asia, the importance of export promotion in respect of achieving a sustainable growth momentum in Sri Lanka cannot be ignored. Nevertheless, among the countries listed in Table 3, Sri Lanka has been one of the poorest export-performing countries during the period of three decades from 1960, and has been the only country that has recorded a negative export growth (1970-80). Many developing countries were reported to have experienced low export growth, when widespread import substitution policies conditioned the

Sri Lanka

development strategies in these countries in the early decades followed by their independence. Against this policy environment, although export performance was poor in many countries in the 1960s and the 1970s, the negative growth of exports in Sri Lanka, which resorted to a highly restrictive trade regime at the time, was an exception. Even in the 1980s, 6.3% of the rate of export growth of Sri Lanka was the lowest among the countries listed in the Table. It was in the first half of the 1990s, in which the average annual rate of export growth was 17%, and during which period Sri Lanka was reported to have reflected outstanding performance in export promotion. Sri Lanka in an Asian perspective reveals an important feature of the growth performance and export expansion over the past few decades. Most of the Asian countries have been apparently progressive, while they differ from each other in terms of the rate of progress in the long run. Generally, the South Asian countries have performed slowly when compared to their counterparts in the Southeast and East Asian region. Sri Lanka was, however, an exception, because it deviated significantly from the general pattern of progress in any region of Asia. Having been based on exceptionally favourable initial conditions, the country made a radical move away from achieving its potential growth performance and was steeped in a deep and prolonged economic stagnancy. By the time it returned from this crisis to explore the potential growth performance, the slowly progressing economies had come closer to it and the rapidly progressive economies had overtaken it.

Growth and Structural Changes

Economic growth Sri Lankas overall growth performance can be described as a modest record with substantial fluctuations and a few peak and trough points. Although primarily the contemporary policy environment of the country could explain the trend growth of GDP, its annual fluctuations could be attributed to a series of random events in the internal and external environment. As Chart 1 shows, the rate of GDP growth has indicated an upward trend from the end of 1950s to the end of 1960s. This is further clear from the five-year annual average rates of GDP growth, which recorded a moderate increase from 2.6% in 1956-60 to 3.6% in 1960-65 and to 5.3% in 1965-70 (Table 4). This is a period in which Sri Lanka experienced a move towards a regime of state intervention and import controls. More stringent controls on imports in the form of tariffs and quota restrictions and drastic measures to limit foreign exchange payments came into effect since 1961. As the economy was heavily dependent on the fortune of traditional export crops, the annual fluctuations in growth performance could be attributed largely to the changes in weather conditions and world market conditions affecting the traditional export crops. The initial stage of an import substitution regime generally shows an expansion of the economy by exploiting easy import substitution opportunities. The upward trend in economic growth was further maintained by policy revisions aimed at gradual and partial liberalization during 1965-70, though within the prevalent import substitution framework. The subsequent period of the 1970s was marked by an episode of reaching the limits of economic expansion under continued and enhanced import substitution strategies and state controls over the economy.

Sri Lanka

Table 4 Annual average rate of economic growth 1950-2000 (%)

Agriculture Mining & quarrying Manufacturing Construction Services GDP

1951-55 1956-60 1961-65 1966-70 1971-75 1976-80 1981-85 1986-90 1991-95 1996-00
Source: Appendix 3

4.4 0.6 2.7 4.2 0.7 4.4 4.6 1.2 2.3 1.4

4.3 2.8 1.4 15.0 72.6 13.0 3.8 9.5 1.1 3.2

1.0 3.4 5.2 7.3 0.7 3.5 5.6 6.7 8.9 7.1

9.4 1.7 -1.0 17.0 -2.5 11.2 -0.7 1.7 5.7 5.1

4.4 3.8 4.6 4.3 4.1 5.8 6.2 3.3 5.6 5.8

4.3 2.6 3.6 5.3 2.6 5.5 5.2 3.4 5.4 5.0

Chart 1 Rate of Growth of GDP and Manufacturing (%), 1950-2000

14.0 12.0 10.0 8.0 Growth rate (%) 6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 Manufacturing GDP

Source: Appendix 3

A major breakthrough in trend growth occurred since the beginning of the 1970s, with a reversal in partial liberalization attempts in 1965-70. With this policy shift, the economy moved to a hard phase of import substitution in a highly controlled regime. Sri Lanka recorded a 0.2% GDP growth in 1971, the lowest during the 50-year

Sri Lanka

period under concern,4 while the average rate of growth was 2.6% for the five-year period 1970-75. The lowest rate of GDP growth in 1971 has been attributed to the adverse impact of an aborted youth insurrection. The adverse spell of the economy during the subsequent years came from global energy, food and exchange rate crises as well as the bad weather conditions. As the global factors were common, much of the weak economic performance could be attributed to the domestic policy environment itself, which made the economy highly vulnerable to the internal and external shocks. Following policy reforms in 1977 which aimed at achieving export promotion in a liberalized trade regime, there was a moderate upsurge in five-year average growth rates to the level of about 5%, except during the latter half of the 1980s. The growth performance in the liberalized trade regime was greater than that in the previous restrictive trade regime. Nevertheless, it appeared that the initial upsurge in the annual rates of growth in the late 1970s slowed down in the 1980s. This resulted from the macroeconomic and political instability of the country. The massive increase in public investment followed by a sharp upsurge in military expenditure disrupted the macroeconomic stability. In addition, a severe blow to the economy came from the twin political conflicts that erupted in the mid 1980s, i.e., the Tamil separatist war in the North and the Sinhala youth militancy in the South. As a result, the average rate of GDP growth came down to 3.4% in the second half of the 1980s. With the initiation of a second wave of trade liberalization process in 1989, and with the governments achievement of military success in repressing the Southern insurrection by the end of the same year, the economy was able to regain its growth momentum to a moderate level. However, in the midst of a series of internal and external shocks, along with the continuation of the separatist war in the North, the average rate of growth remained around 5% in the last decade of the twentieth century. Composition of production The long-term growth performance is characterized by an increase in the share of manufacturing and service sectors with a decline in the share of the agriculture sector. Chart 1 shows that until the mid 1980s the annual growth of the manufacturing sector has been rather erratic and has not moved closely with GDP growth. Even though there has been an upward trend in manufacturing growth in the 1960s, it has slowed down significantly in the 1970s. The mid 1980s was a turning point in terms of growth performance. The growth of the manufacturing sector continued to remain above GDP growth and started to move closely with GDP growth, indicating that it had become the major dynamic sector that determined trend growth of GDP. The long-term change in the share of manufacturing in GDP is worthwhile noting since it shows a clear division of manufacturing growth into four phases (Chart 2). Followed by an initial phase of decline in the manufacturing share from 12% to 10% in the first half of the 1950s, there has been an increase in its share until the early 1970s. The continuity in manufacturing growth was disrupted again, as the share of
In certain studies, the rate of GDP growth in 1971 is reported as a negative figure. For instance, see Athukorala and Jayasuriya (1994: 134), which gives 0.8% rate of GDP growth. As it was reported at the time of writing, the lowest GDP growth performance of Sri Lanka during its post-independence history was recorded in 2001; this year the rate of GDP growth was 1.4% (CBSL: Annual Report 2001) Sri Lanka 10
4

manufacturing reported a declining trend throughout the 1970s, in bringing it back nearly to the level of the mid 1950s. It was only after the mid 1980s that the share of manufacturing recorded a steady upward trend, arriving at above 16% of GDP in the latter half of the 1990s. Chart 2 Share of Manufacturing in GDP (%), 1950-2000
20 Manufacturing share (%) 18 16 14 12 10 8 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Source: Appendix 3

Table 5 Sectoral Composition of GDP (%) 1950-2000

Agriculture Mining and Quarrying Manufacturing Construction Services

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Source: Appendix 3

42.4 42.6 39.4 37.8 35.5 33.0 31.3 30.6 27.8 24.3 20.5

0.3 0.3 0.3 0.3 0.4 1.4 1.8 1.7 2.3 1.9 1.7

12.0 10.2 10.8 11.8 12.8 11.9 10.8 11.1 13.2 15.7 17.4

6.4 7.8 7.3 5.8 9.7 7.6 9.5 7.2 6.7 6.9 7.0

38.9 39.1 42.2 44.3 41.8 46.1 46.6 49.4 50.0 51.2 53.4

As Table 5 shows, the share of agriculture as a percentage of GDP declined from 42.4% in 1950 to 20.5% in 2000. By 1980, the share of agriculture had declined by

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11

26% points, and subsequently by a further 35% points in the last two decades when GDP growth rose to a higher contour. Corresponding to such decline, the service sector recorded the highest gain, as it continued to rise in its share from 38.9% of GDP in 1950 to 53.4% in 2000. When compared to the rapid increase in the share of service sector, the share of manufacturing has increased rather slowly from 12.0% of GDP in 1950 to 17.4% in 2000. Manufacturing: composition and factor productivity Significant structural shifting is visible within the sectoral components of GDP as well. These transformations are a feature of the second half of the post-independence period in particular. Within manufacturing there is a clear shift to factory industry while the share of small industry and export processing activities (of tea, rubber and coconut) has declined. Within a period of 30 years till 2000, the share of factory industry has increased from 49.4% of total manufacturing production to 80.6% (Table 6). Correspondingly, the share of export processing has declined from 40.6% to 12.0% and, that of small industry, which recorded an increasing share in total manufacturing until the mid 1980s, has declined to 7.4% during the same period. Table 6 Composition of Manufacturing Production (%) Factory Small Export Industry Industry Processinga 1970 40.6 49.4 10.0 1975 36.8 51.2 12.0 1980 29.5 55.5 15.0 1985 19.9 66.8 13.3 1990 15.7 76.2 8.1 1995 10.9 82.1 7.0 2000 12.0 80.6 7.4
a: Processing of traditional export crops, i.e. tea, rubber and coconut Source: CBSL (annual issues): Annual Reports

The sectoral composition of output and employment in the total manufacturing sector shows an increasing importance of labour-intensive industries such as food, beverages, textile, wearing apparel and leather. These dominant industries alone accounted for over 50% of total manufacturing output and over 60% of total manufacturing employment after the late 1980s. The dominant manufacturing activities in the import substitution regime concentrated on the sectors such as chemicals, petroleum, rubber and plastic industries, which contributed over 50% of the manufacturing output in 1980. However, it accounted for less than 15% of the manufacturing employment as compared to the high share of output, indicating the capital intensity of production. Generally, the rapid growth of labour-intensive industries resulted in a corresponding decline in the share of output and employment in many industries that emerged in the import substitution regime.

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12

On average, the total factor productivity in the manufacturing sector increased by 6.5% during 1980-88, 4.0% during 1988-94 and, by 1.9% during 1994-98 (Table 7). The results are consistent with the period-specific policy changes. During the initial period of trade liberalization, the growth of employment and capital stock was more in non-tradable sectors than in manufacturing. Therefore, the increase in real value added in manufacturing was contributed to by the greater improvement in factor productivity. In contrast, both manufacturing employment and real capital expanded rapidly during the period of 1988-94. Therefore, the real value added increased not only through the improvement in factor productivity but also through an increase in factor inputs. During the period 1994-98, the real value added in manufacturing decreased along with declining labour inputs and real capital. Table 7 Total Factor Productivity Growth in the Manufacturing Sector (Annual compound growth rates) 1980-88 1988-94 1994-98 Food, beverages and tobacco 0.1 11.3 5.1 Textile, wearing apparel and 5.0 9.1 -3.9 leather Wood, wood product and furniture -4.8 10.1 6.8 Paper, printing and publishing 9.5 8.3 -11.9 Chemicals, petroleum, rubber and 9.2 -2.9 0.7 plastic Non metallic mineral product 5.0 -12.5 12.6 Basic metal industries -2.0 47.0 -45.9 Fabricated metal product, -2.0 10.1 0.4 machinery and equipment Other manufacturing 23.7 3.0 -7.0 Total manufacturing 6.5 4.0 1.9
Source: Appendix 3

The growth of total factor productivity has been highly dispersed across the manufacturing sectors and between different periods within the liberalized trade regime. At sectoral comparison, the dominant and dynamic manufacturing industries such as food, beverages and tobacco industry, textile, wearing apparel and leather industry, chemicals, petroleum, rubber and plastic industry and, other manufacturing have shown remarkable improvement in total factor productivity. Most of the products that fall under these industrial categories have been labour-intensive export-oriented manufacturing activities that grew fast in the liberalized trade regime. Along with a greater improvement in factor inputs, the total factor productivity of the most dynamic manufacturing sector, i.e., the textile, wearing apparel and leather industry, has also improved significantly by 5.0% during 1980-88 and, by 9.1% during 1988-94. The latter part of the liberalized trade regime, i.e., 1994-98, has been marked by a decline in total factor productivity in many sectors, including export-oriented textile, wearing apparel and leather industry and other manufacturing activities. These indicators are consistent with poor export performance

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13

since the mid 1990s, as we explore later. During this period, on average the labour inputs as well as real capital stock have also indicated a substantial decline. Unlike in the import substitution regime, the expansion of manufacturing activities in the liberalized trade regime has been consistent with the fact that, given the present level of development, Sri Lankas comparative advantage is in labour-intensive manufacturing production. In the total manufacturing sector, the labour absorption has been faster than the increase in capital stock. This suggests that labour has contributed largely to the total factor productivity growth. In fact, capital deepening does not seem to have been an important factor in explaining labour productivity growth even in highly capital-intensive industries (Athukorala 1996). The changes in factor inputs and productivity growth in manufacturing have been in line with changes in policy emphasis on manufacturing development. Agriculture: composition and land productivity While the economy has over the years been diversifying itself, moving away from its heavy dependence on the traditional modes of activity, the significance of agriculture should not be underestimated. With agriculture still accounting directly for a fifth of the GDP, its performance is crucial in determining the tempo of economic growth. In years when weather adversities affected agricultural output such as in 1965, the early 1970s and more recently in 1992 and 1996, it depressed overall growth. Within agriculture, the export crops, which constituted the engine of growth in the classical colonial economy, altogether accounted for about 60% of total agriculture production in 1950 and declined to about 17% by 2000 (Table 8). Meanwhile, the share of other domestic agricultural activities has shown a rapid expansion indicating a significant diversification within the overall agriculture sector. Table 8 Composition of Agriculture Output (%) Tea Rubber Coconut Paddy 28.3 16.0 15.9 28.7 9.7 11.8 11.3 6.2 14.3 25.5 11.1 5.9 13.6 17.1 9.7 3.0 13.5 23.9 10.0 2.4 10.9 21.3 9.4 2.1 10.5 21.0 7.0 1.8 8.6 15.9

1950a 1960a 1970 1975 1985 1990 1995 2000

Otherb 39.9 49.8 42.6 52.3 49.9 55.5 57.0 66.7

a: In the original data source, tea is defined as 'Tea and Minor Export Crops', while Paddy Production is not given separately. b: Other includes other agricultural crops as well as forestry and fishing. Source: Snodgrass (1966: 129) for 1950 and 1960, CBSL (annual issues): Annual Reports for other years

By the second half of the century, the plantation agriculture ran into constraints of land for expansion and unfavorable price trends in the international market. In fact, the extent of land used for plantation crops declined towards the end of the
Sri Lanka 14

century when compared to the 1970s, while rubber plantations recorded the most rapid decline (Table 9). Nevertheless, the land productivity in plantation agriculture has shown a substantial improvement, particularly in tea and coconut in the last two decades. Meanwhile, the paddy sector was able to make headway reflecting the major breakthrough made by the seed-fertilizer revolution and subsequent acreage expansion. Table 9 Main Agricultural Crops: Land and Land Productivity 1950-2000 Tea Rubber Coconut Paddy Hectares Annual Hectares Annual Hectares Annual Hectares Annual (1000s) yield per (1000s) yield per (1000s) yield per (1000s) yield per hectare hectare hectare hectare (kg) (kg) (nuts (metric 1000s) tons) 227 612 265 434 433 4.6 431 1.1 235 838 270 367 433 5.0 595 1.5 242 876 273 586 466 5.4 759 2.1 245 780 227 586 424 4.8 845 2.5 222 1050 199 568 384 6.6 857 3.0 180 1700 158 551 439 7.0 878 3.3

1950 1960 1970 1980 1990 2000

Source: CBSL (2000)

As Table 9 shows, the extent of land used for paddy cultivation has doubled, while paddy productivity has trebled during the period 1950-2000. From the late 1970s to the early 1980s paddy performance was the main component supporting agricultural growth. The Green revolution in Sri Lanka had its first breakthrough in the 1960s with high yielding varieties and a second breakthrough in the 1970s when new improved seed strains raised yield potential against traditional varieties. The subsequent output gains came from the vast agricultural infrastructure developments of the Mahaveli River Diversion programme of 1978-82, which led to an expansion of the cultivation area. The expansions of land and land productivity in paddy have enabled the country to achieve near self-sufficiency.

Savings and Investment

As a low income economy Sri Lanka has a consumption propensity of over 80% reported for the entire period of 1960-2000. Accordingly, the domestic savings to GDP ratio stood between 11-15% during most years (Chart 3). A notable exception has been the slump of the domestic savings ratio in the mid 1970s, when it reportedly declined to about 8% of GDP. An upward bounce of the ratio above 18% level was reported only in few years, 1977 (18.1%), 1984 (19.9%) and 1998-99 (over 19%). It is noteworthy that tea price booms marked all these years. A slow pace of upward trend is visible in the 1980s and 1990s with the rise in per capita income in the countrys liberalized trade regime. The national savings that remained lower than the domestic savings until 1977, started to rise above domestic savings in the 1980s and the 1990s (Chart 3). Net factor income from abroad continued to remain negative. However, the Sri Lankan
Sri Lanka 15

workers in overseas employment have constituted a major resource medium supplementing the domestic savings volume in the last two decades of the century. Remittances so received from them have risen over the years to as much as 5-6% of GDP. Largely for this reason, the net private transfers were reported to be positive and rising over time after the late 1970s. By the late 1990s the national savings ratio stood at above 20% of GDP. The surplus that the pre-capitalist economy of peasants and small holders could generate for investment purposes was essentially limited. But the colony's exposure to foreign investment at an early stage of its modern economic development had helped to counteract the disadvantage of a low domestic capital formation implicit in low savings. Much of the limited indigenous capital accumulation went into small-holdings (primarily coconut) and to trading activity. Under the free trade policy pursued during this early period there was little industrial accumulation. Indigenous capital subsequently moved into plantation investment to buy up estates, which went up on sale following political independence. However, many Sterling companies retained their financial stake in the country under the peaceful transfer of political power and the pro-Western, procapitalist leanings of the indigenous political leadership that took over governmental reins. Sri Lanka did not experience a large flight of capital as it happened in some other countries following political independence. Chart 3 Savings and Investment 1960-2000
40.0 35.0 Percentage of GDP 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000
Domestic Savings National Savings Investment

Source: Appendix 4

Reviewing the behaviour of savings and investment, it is to be noted that up to the mid-1970s capital formation follows savings behaviour rather closely (Chart 3). Both investment and savings ratios were low. The investment ratio fluctuated around 15% of GDP until 1977, with a notable exception of 19.3% reported in 1969. The

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16

national savings ratio remained within the range of 10-15%, also with an exceptional decline in the mid-1970s. For both ratios, the 1960s record a cyclical pattern of decline in the first half in which the country moved into a restrictive regime and, of recovery in the second half when the country experienced a mini liberalization regime. This is suggestive of some relationship in the behaviour of national savings with the shift in policy regimes between regulation and liberalization in the two halves. An important feature to note is the change in the gap implied between the savings and investment ratios since the late 1970s (Chart 3). The sharp rise in the investment ratio in the late 1970s and the early 1980s reflects capital inflows from external sources (concessional aid from bilateral and multilateral sources and, FDI flows) following the economic liberalization reforms of 1977. Concessional aid from external sources financed the large public investment programmes of the new regime. Subsequently, as the major investment projects of the public investment programmes neared completion, the ratio dropped from this peak and continued to decline until the end of the decade. During this phase, the government had in view of the overheating of the economy, taken a decision not to launch new capital projects of comparable magnitude. The unstable political situation resulting from the eruption of the twin civil wars in the mid 1980s also contributed to the decline in the investment ratio. The pattern in the 1990s is a recovery in the first half following temporary restoration of peace. Following the change of government in 1994 there was another short cycle of decline during 1994-96. Chart 4 Gross Domestic Capital Formation 1960-2000
30.0 25.0 Percentage of GDP 20.0 15.0 10.0 5.0 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 Private Governm ent

Source: Appendix 4

The contribution of FDI provided a supplementary source of investment when the heavy flow of foreign aid of the early post-reform years began to lose its momentum.
Sri Lanka 17

However, the gap between savings and investment has been narrower towards the end of the 1990s as a result of rising domestic and national savings. This tallies with the broad elevation of the GDP growth rate and migrant worker remittances, which pushed the savings ratio up by several percentage points. In an overall assessment of the investment behaviour during the liberalized regime, it is nevertheless clear that the country has failed to maintain the initial upsurge in the investment ratio after the mid-1980s. The composition of gross domestic capital formation (GDCF) shows the growing importance of private investment within the total with a decline in the share of public investment. Compared to the ratio of about 60-70% of GDCF in most part of the 1960s-1970s, the share of private capital in total GDCF increased to over 80% in most of the 1980s-1990s and remained closer to 90% level since the mid 1990s. Throughout the period of five decades the government investment as a percentage of GDP remained fluctuating around 5% level, with notable exceptions due to an upsurge in the early 1980s and due to a decline in the 1990s (Chart 4). With massive public investment programmes accompanied by foreign aid flows during the early years of trade liberalization, the government investment reached the peak point of 8.6% in 1980. The subsequent years after 1994 were marked by a historical decline in public expenditure in the region of 3-4% of GDP with the governments commitment to achieve macroeconomic stability through fiscal prudence. Private investment, which recorded a substantial increase after the late 1970s, appears to have responded largely to the changes in policy regimes and business environments. The latter half of the 1960s witnessed a resurgence in private investment with an increase in its contribution from 7.5% of GDP in 1965 to 14.5% in 1970 in responding to the partial liberalization programme of the government. This was, however, reversed in the subsequent restrictive trade regime of 1970-77 in which the public sector expanded at the expense of the private sector. A major breakthrough came with the radical policy reforms for trade liberalization in 1977 as the private investment grew rapidly from a ratio below 10% of GDP to around 25% in the early 1980s (an increase by about 150% point).

Fiscal Operations
The behaviour of the governments fiscal operations primarily indicates the budgetary responses to the changes in policy regimes. However, the overall trend reflects a longterm deterioration of the sound budgetary position enjoyed in the 1950s. Thanks to the thriving plantation export crops and their favourable world market conditions, the government revenue rose closer to 25% of GDP in the mid 1950s (Chart 5). Consequently, the overall fiscal balance recorded a surplus, which was the only surplus during the period of past five decades (Chart 6). For about two decades after the late 1950s, the government revenue remained around 20% of GDP with signs of long-term deterioration. In addition, the recurrent expenditure, which increased in the second half of the 1950s, was getting closer to the revenue level. The capital expenditure, though with annual fluctuations, continued to remain in the range of 5-10% of GDP throughout the period of 1950-1977 with notable exceptions above 10% level in 1957 and in 1976. It is, however, surprising that the capital expenditure behaved rather constantly in an increasingly restrictive trade regime
Sri Lanka 18

in which the role of the government expanded over that of the private sector. It appeared to have been subject to the resource constraint along with the given level of high recurrent expenditure and the governments commitment to maintain fiscal prudence. The current account balance, which indicated a healthy surplus in the mid 1950s, deteriorated subsequently and turned to show even frequent deficits since the late 1960s. The overall fiscal balance continued to remain as a deficit amounting to over 5% of GDP until the mid 1970s. A major disruption in the existing pattern of fiscal operations came at the initial stage of trade liberalization. In responding to the drastic measures of the liberalization process, there had been a sharp rise in both revenue and expenditure in reporting their highest ratios of GDP throughout the entire period (Chart 5). As Table 11 shows, the total expenditure was around 20% of GDP in the 1950s and, remained in the region of 26-28% of GDP in the subsequent period up to the mid 1970s. This went up to 42.7% of GDP in 1980 and remained above 30% level throughout the decade. This was largely a result of a nearly doubled capital expenditure in the 1980s from its historical level of 6-8% of GDP in the two previous decades. Chart 5 Government Revenue and Expenditure 1950-2000
30.0 25.0 Percentage of GDP 20.0 15.0 10.0 5.0 0.0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 Revenue 2000

Current expenditure

Capital expenditure

Source: Appendix 5

There is little dispute among policy makers and analysts over the fact that Sri Lankas fiscal operation has gradually been constrained by the emergence of its fundamental weaknesses throughout the post-independence era. For example, as Table 10 shows, there has been a massive increase in the share of transfer payments to the private individuals and public sector institutes until the mid 1970s. During the period of 20 years, the transfer payments have increased from 15.1% of total government expenditure in 1954/55 to 38.5% in 1975. A major component that contributed to this has been the

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increase in transfer payments to private individuals of which food subsidies alone were reported to have increased from 3.4% of the total expenditure in 1954/55 to 17.1% in 1975. Table 10 Changing Patterns of Government Expenditure on Selected Items 1950-2000 (as % of total expenditure)
Year Private transfers Total Food (cash) subsidies Public transfers Total transfers Defence Interest payments

1949/50 1954/55 1959/60 1964/65 1969/70 1975 1980 1985 1990 1995 2000

14.4 12.9 21.2 26.1 28.6 34.9 19.8 25.3 15.3 14.4 12.5

4.5 3.4 10.6 12.9 14.7 17.1 1.1 0.2 5.1 (2.9) 0.9 (2.5) 0.1 (2.9)

2.6 2.2 2.0 1.7 3.4 3.6 6.8 4.5 5.7 5.5 3.1

17.0 15.1 23.1 27.8 32.1 38.5 26.6 29.8 21.0 19.9 15.6

0.6 1.7 2.4 2.4 2.3 2.7 1.6 8.0 6.7 17.3 16.9

2.5 3.1 2.9 4.7 6.5 9.7 8.0 14.7 20.7 18.8 21.2

Notes: Prior to 1973, the financial year, which did not coincide with the calendar year, refers to the period from October 1 in the previous year to September 30 in the current year. The figures in parentheses refer to the share of direct cash subsidies to low-income groups, initiated since 1989. Source: CBSL (various issues): Annual Reports

During the post-1977 liberalized trade regime, generally the expenditure share of transfer payments had declined to its initial levels in the 1950s. Its positive impact on the fiscal balance has, however, been compensated by an unprecedented increase in the share of expenditure on defence and interest payments. The defence expenditure that remained around 2% of the total expenditure in the first three decades, had increased by about four-times in the 1980s, and by over eight-times in the 1990s due to the countrys civil wars. Along with this, the share of interest payments on public debt increased to double-digit level after the mid 1980s, and accounted for 21.2% of the total expenditure in 2000, in becoming the largest single expenditure component in the budget. Its sharp rise after the mid 1980s was due to the large budget deficits as a consequence of the massive increase in public expenditure on infrastructure during the initial stage of trade liberalization. Over half of the total expenditure was thus absorbed by transfers payments, defence expenditure and interest payments since the mid 1990s. Interestingly, this situation was not much different from that of the mid 1970s, when an increased share of the total expenditure was absorbed by transfer payments even with small shares of defence expenditure and interest payments.

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Chart 6 Government Fiscal Balance 1950-2000

10.0 5.0 Percentage of GDP 0.0 -5.0 -10.0 -15.0 -20.0 -25.0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
1995

Current account balance Overall balance 2000

2000

Source: Appendix 5

Chart 7 Government Debt as % of GDP 1950-2000

7 0 .0 6 0 .0 5 0 .0 4 0 .0 3 0 .0 2 0 .0 1 0 .0 0 .0 1950 1955 1960 1965 1970 1975 1980 1985 1990 D o m e s ti c F o re ig n

Source: Appendix 5

Despite an initial upsurge in revenue and expenditure following trade liberalization, the period after the late 1980s was marked by a substantial change in fiscal operations and a worsening of its fundamental weaknesses. Both revenue and expenditure declined and the budget deficit fell to around 10% of GDP, which is still considered to be high as far as the macroeconomic stability of the country is concerned. The reduction in

Sri Lanka

Percentage of GD P

21

the budget deficit was attributable largely to the steady decline in capital expenditure in the 1990s to a level that it had in the 1970s before liberalization (Chart 5). For most part of the period after 1960, the behaviour of the budget deficit was analogous to that of capital expenditure. This fundamental weakness of the fiscal operations in Sri Lanka appears to have been aggravated further in the 1990s as the recurrent expenditure started to remain greater than the total revenue, constituting a constant current account deficit as well (Chart 6). The deficit in the current account as a percentage of GDP was reported to be 1.2% in 1990, 2.7% in 1995 and 3.4% in 2000. Therefore, recurrent expenditure of the government also started absorbing from deficit financing that was allocated to cover primarily the capital expenditure for about three decades prior to 1990. The long-term worsening fiscal operations have resulted in an accumulation of government debt and an increased reliance of the government on foreign debt. With a notable low debt ratio of around 16% in 1950 and 1951, the total government debt remained around 20% of GDP for most of the years until 1956 (Chart 7). This owed much to the sound fiscal position of the government as well as to the limited role that the government played in the free market economy at the time. Domestic debt recorded a sharp increase during the period of 1957-67 and since then for most of the years remained in the region of 40-50% of GDP. Foreign debt, which was less than 10% of GDP, showed a moderate increase during the initial period until 1965. Prior to trade liberalization, the governments resorted mainly to domestic sources of financing the budget deficit. As a result, domestic debt continued to grow from around 20% of GDP in the latter half of the 1950s to about 50% in the latter half of the 1960s. This scenario changed particularly during the initial phase of the liberalized trade regime. Foreign debt showed a sharp increase after the mid 1970s and reached its peak point of over 60% of GDP by 1989. This was a result of an increased reliance on foreign borrowings to finance the growing budget deficit.5 The total debt though with minor fluctuations in the short-run shows a sharp increase over the past five decades of the twentieth century. Since the late 1980s, it remained above 90% of GDP, except in 1997the year the economy recorded a 6.3% GDP growth. In fact, the total government debt was greater than the GDP in the late 1980s, when the foreign debt increased to its historical peak levels.

External Trade and Finance

The long-term behaviour of international trade and finance in Sri Lanka presents an interesting case of a small economy organized under changing policy regimes. An analysis clearly shows how the countrys initial prosperity and trade dependence was changing with a deteriorating external finance position in its increasingly restrictive regime. In contrast, it also reflects the drastic structural changes in international trade and finance in the subsequent liberalized trade regime.
In addition to the amount of financing generated from the typical domestic sources, the funds generated through privatization of the public enterprises have also become a new source of financing budget deficit after 1991. Privatization proceeds of the government have generated deficit finance on average 0.6% of GDP per annum during the period 1991-00, with a notable exception of 2.5% in 1997 (CBSL, various issues, Annual Reports). Sri Lanka 22
5

Exports and imports Owing to the flourishing plantation crops of a classical export economy, Sri Lanka began its post-independence development history with a high trade dependence ratio, measured by the share of exports and imports to GDP. In the early 1950s, exports and imports accounted for 40% and 30% of GDP respectively (Chart 8). Within a subsequent period of about 25 years of an increasingly restrictive trade regime, both exports and imports declined to their minimum of around 15% of GDP. The thriving plantation export crops and their favourable world market conditions resulted in a healthy surplus in trade balance in the early and mid 1950s. Although it was deteriorating from the second half of the 1950s to the second half of the 1970s with backward export performance, the deficit was kept low forcefully through increased controls on imports. There was an upsurge in exports and imports at the early stages of trade liberalization after 1977 with the former accounting for about 30% and the latter for about 50%, as a percentage of GDP. Even though this initial upsurge in export and import ratios declined since then, they recorded a moderate increase after the late 1980s. Since the mid 1990s the countrys trade dependence seems to have returned to its initial level of around 70% in 1950, but with widened trade deficit throughout the liberalized trade regime. Chart 8 Exports and Imports as % of GDP 1950-2000
60 50 Percentage of GDP 40 30 20 10 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 E x ports Im ports

Source: Appendix 6

In response to the changes in trade regimes, the change in the classical colonial structure of export and import trade was marginal in the first half and substantial in the second half of the past 50 years. In the 1950s, over 90% of exports comprised plantation crops, which constituted the backbone of the economy at the time (Table 11). A remarkable change in the export structure was reported only after the mid 1970s in the liberalized trade regime. The dominance of agriculture in the structure of exports that

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23

accounted for 78.7% of the total in 1975 was replaced by industrial exports that accounted for 77.6% in 2000. Along with the changing export composition in the liberalized trade regime, the structure of the imports too changed. Throughout the period until the mid 1970s, over half of the total imports were consumer goods. In the postliberalized trade regime this has been replaced by an increasing share of intermediate goods, which accounted for 53.5% of the total imports. Table 11 Composition of Exports and Imports 1950-2000 Exports as % of total Imports as % of total Agricultural Industrial Other Consumer Intermediate Investment exportsb exports goods goods goods exportsa 93.7 6.3 51.0 10.1 38.9 91.2 8.8 51.7 16.4 31.9 90.5 9.5 61.0 20.3 18.1 93.8 6.2 52.8 28.1 17.7 91.7 8.3 55.4 20.0 23.6 78.7 13.2 8.1 50.5 36.0 12.4 61.8 33.0 5.2 29.9 45.7 24.0 52.5 39.5 8.0 19.4 54.3 19.2 36.3 52.2 11.4 26.4 51.8 21.7 21.8 75.4 2.8 18.5 54.6 22.4 18.2 77.6 4.2 17.3 53.5 23.6

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

a: Until 1963, agricultural exports include tea, rubber and coconut only as minor agricultural exports have been categorized under other exports. b: Until 1971, industrial exports that were not reported separately have been categorized under other exports. For 1972, industrial exports accounted for 2.8% of total exports. Source: Appendix 6

The long-term behaviour of trade indices in the country is interestingly analogous to the changing pattern of its international trade. Export and import value indices have hardly changed in the first half of the past 50 years as compared to their rapid increase in the second half (Chart 9). In the first half (1951-75), the export value index has increased by an average 4% per annum and the import value index by an average 6% per annum. In the second half, they have increased respectively by 21% and 25% per annum. The terms of trade were constantly on the deteriorating path in the long run in a primary-exporting economy characterized by stagnant export and import structures. Furthermore, the terms of trade recorded substantial short-term fluctuations until the beginning of the 1980s in reflecting a high degree of vulnerability of the economy to external shocks. The short-term developments in terms of trade, such as those in 1950-51, 1954-55 and in 1977, were mainly the results of the price hikes in international markets favouring the countrys primary exports. Perhaps an exception to this typical pattern of the upward movement of the terms of trade was reported in 1968. In this year the price hike was combined with the effects of policy changes favouring export expansion in the
Sri Lanka 24

short-lived mini liberalization period of 1965-70, as we discuss later. Among the external shocks, the oil price hikes in 1973-75 and in 1979-82 had a bearing impact on the terms of trade of the country. It is worthwhile noting that with the changing export structure in the post-1977 liberalized trade regime the terms of trade were relatively stable and free from wide fluctuations. It points to an improved capacity of the economy to absorb the effects of external shocks. This is largely a result of the rapid decline in the share of primary exports and a corresponding increase in the share of industrial exports.

Chart 9 Trade Indices 1950-2000

600 500 Index (1990=100) 400 300 200 100 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Term s of trade Exports value Im ports value

Source: Appendix 6

Balance of payments There have been remarkable changes in the balance of payments position of the country in reflecting the main features associated with the changes in policy regimes. The relative importance of current and capital accounts in determining the overall balance of payments position of the country has changed substantially overtime. Generally the current account balance has recorded an increasing share of deficit while the capital account an increasing share of surplus of the balance of payments throughout the period of the past 50 years. These changes could be attributed to the major elements of the respective trade regimes. Table 12 shows balance of payments, aggregated to five-year totals, during the period of 1950-2000. Started with a surplus of US$ 0.06 billions in 1950-55, the overall balance turned into a deficit in the subsequent period until the mid 1970s. The major component that contributed to the initial balance of payments surpluses and the subsequent deficits has been the trade account. The capital account, which was negative at the initial stages (1950-55 and 1956-60), improved slowly in accounting for about US$ half a billion in 1971-75. This improvement in the pre-1977 restrictive trade regime

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25

appears to be marginal when compared to the rapid growth of the net capital flows in the 1980s and the 1990s after the introduction of the liberalized trade regime. In addition to the governments long-term borrowing, in the liberalized trade regime the growth of the capital account surplus was contributed by the FDI and portfolio investment flows. Along with growing net capital flows, trade deficit, which accounted for less than US$ 1 billion in 1970-75, recorded a sharp rise to about US$ 23 billion in 1995-2000. However, the current account deficit grew slower than the trade deficit. This was a result of a remarkable increase in net transfers in the liberalized trade regime. Particularly, the net private transfers, which were negative until the 1970s, recorded a growing positive balance in the liberalized trade regime due to increased foreign exchange earnings of migrant workers. Table 12 Balance of Payments 1950-2000 (US$ billion) Trade Current Capital balance account account 0.21 0.05 -0.02 0.13 -0.09 -0.01 0.00 -0.20 0.04 -0.38 -0.57 0.25 -0.91 -0.91 0.58 -2.59 -1.76 1.46 -6.44 -3.71 3.52 -10.02 -5.57 5.17 -16.28 -8.88 9.45 -23.10 -11.81 11.86

1950-55 1956-60 1961-65 1966-70 1971-75 1976-80 1981-85 1986-90 1991-95 1996-00
Source: Appendix 7

Overall balance 0.06 -0.08 -0.14 -0.19 -0.09 0.37 0.58 0.39 1.82 1.17

As the growing deficit in the current account was more than compensated by the net capital flows, the overall balance recorded surpluses in most part of the 1980s and the 1990s. Annual changes in the balance of payments position during 1950-2000 are shown in Chart 10. The magnitude of the current and capital account balances was greater in the second half than in the first half of the five decades in maintaining the balance of payments equilibrium. Among them, the overall balance has moved closely with the behaviour of the current account, as the capital account appears to be less volatile than the current account. The large variations in the current account and, hence the overall balance, were due to external shocks (e.g. price booms in 1950-51, 1954-55 and 1976-77) and the changes in internal policy measures (e.g. currency devaluation in 1949, 1967). The changes in weather conditions that affected the export performance of the plantation crops were also a major determinant of the variation in the current account. In an overall assessment, however, the current account deficit in the economy dominated by primary exports appears to have been kept low through increased restrictions on import trade.

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26

Chart 10 Balance of Payments as % of GDP 1950-2000

15.0 10.0
Percentage of GDP

5.0 0.0 -5.0 -10.0 -15.0 -20.0

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Current account balance Capital account balance Overall balance

Source: Appendix 7

In the post-1977 liberalized trade regime, the gap between the current account deficit and the capital account surplus, which recorded a near symmetrical move, has widened. At the initial stages of trade liberalization, the current account deficit grew sharply in reporting the ever-highest deficit of over 15% of GDP in 1980. This is not unusual, as imports facilitated by the an upward swing in terms of trade in 1976, responded instantly to trade liberalization in 1977, whereas export growth showed a considerable time lag. Therefore, over time the trade deficit has declined with export expansion and remained at around 5% of GDP after the mid 1980s. In a similar way, the surplus in the capital account has also increased to around 10% of GDP in the early 1980s, but recorded a decline during the period of severe political instability. It was pushed up again in the early 1990s following the partial restoration of peace and the second wave of trade liberalization. The signs of recovery again disappeared in the second half of the 1990s with the capital account surplus falling below 5% of GDP. This was also a response largely to the intensification of the war in the North with increased military expenditure. The behaviour of the capital account in the liberalized trade regime reflects the signs of growing long-term capital inflows in the late 1970s and the late 1980s to reach its potential levels under normal circumstances. Nevertheless, each time the potential growth of capital inflows appear to have been constrained by the growing political instability, as was the case in the second half of the 1980s and the 1990s. Exchange rate Sri Lankas exchange rate system has gone through dramatic changes from an initial fixed to recent floating exchange rate systems. At the time of independence, the country

Sri Lanka

27

had a fixed exchange rate pegged to the Sterling pound under the Bretton Woods international monetary system. Following an amendment to the Currency Law in 1949, the country gained flexibility to determine its exchange rate. With the devaluation of the Sterling Pound in 1949, Sri Lanka devalued the rupee by 30% against the US dollar, by fixing its value as SLRs 4.76 per US dollar and SLRs 13.33 per Sterling pound. The fixed exchange rate system continued until 1977. But the foreign exchange market was not free throughout the entire period as the government resorted to restrictions on foreign exchange payments, which were intensified in the 1960s and the 1970s. In 1967, the Sri Lankan rupee was devalued by 19.5% in real terms against the US dollar, which was followed by an introduction of a dual exchange rate system. In 1976, the link with the Sterling pound was abandoned and the exchange rate of the Sri Lankan rupee was determined against a basket of currencies. Table 13 Exchange Rates and Consumer Prices 1961-2000 Exchange Ratea Change in Consumer (point-to-point % change) Prices Nominal 1961-66 1967b 1968-74 1975-76 1977 b 1978-88 1989 b 1990-96 1997-99 2000 b -0.6 -19.4 -11.4 -25.9 -43.3 -71.2 -17.4 -33.8 -35.3 -9.9 Real -1.6 -19.5 -2.7 -31.5 -46.1 -11.1 -12.2 +26.2 -3.1 -7.5 Annual average (%) 1.4 2.5 7.1 4.0 1.1 12.7 11.5 12.7 7.9 6.2 Relative to USA 0.9 0.9 1.2 0.5 0.2 2.0 2.4 3.7 3.9 1.8

a: Depreciation is given by minus sign and, appreciation by plus sign. Estimates are based on the US$ value of the SLR. b: 1967, 1977, 1989 and 2000 are the years, in which the currency was devalued. Source: Appendix 8

A major breakthrough in the exchange rate system came as a part of the 1977policy package for trade liberalization. Following the policy reforms, a managed floating exchange rate system was established with a unification of the exchange rate system and a drastic devaluation of the currency by about 46% against the US dollar. A second devaluation of the currency in the liberalized trade regime took place 12 years later. With the second wave of policy reforms in 1989, the Sri Lankan rupee was devalued by about 12% in real terms against the US dollar. In the second half of the 1990s the economy began to experience a slow down in export promotion, a worsened balance of payments and a drain of external reserves. In response, the Central Bank widened the spread between buying and selling rates of foreign exchange resulting in a de facto devaluation

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28

of the currency by 7.5% in real terms against the US dollar in 2000.6 In January 2001, Sri Lanka moved into a freely floating exchange system as the Central Bank abandoned the management of its daily rates. Table 13 shows the percentage changes in the nominal and real exchange rates (NER and RER) against the US dollar as well as the behaviour of consumer prices for the period of 1960-2000. As the estimate of the real exchange rate is sensitive to the base year chosen (1960), the differences in the price indices used, and the international currencies selected, the results need to be treated with caution. Because it was a fixed exchange rate system, the nominal exchange rate did not depreciate much prior to 1977. The low inflationary regime in which the rate of inflation was even lower than that of the USA has facilitated the maintenance of the fixed exchange rate system. After the devaluation in 1967, however, the exchange rate has depreciated slower in real terms than in nominal terms indicating an overvaluation of the Sri Lankan rupee. In the liberalized trade regime, Sri Lanka entered into a higher inflationary regime in which the rate of inflation was at double-digit level for most of the time until the mid 1990s. The effects of the drastic devaluation of the currency in 1977 and the subsequent nominal depreciation on the real exchange rate appear to have faded away towards the end of the 1980s. During 1978-88, the exchange rate had depreciated by 71.2% in nominal terms, but the real depreciation was only by 11.1% against the US dollar. During this period, the Sri Lankan rupee was found to be highly overvalued in real terms against the currencies of most of the trading partners and competitor countries of Sri Lanka (Econsult 1994). The first half of the 1990s was marked by a significant overvaluation of the currency in real terms by 26.2% against the US dollar. Generally, the real appreciation of the currency in the liberalized trade regime appears to have been led by a higher inflationary pressure in the domestic economy. Towards the last few years in the 1990s, despite a significant reduction in domestic inflation, the aggravated balance of payments position exerted a substantial pressure on the exchange rate. Therefore, the adoption of a freely floating exchange rate system by withdrawing its management by the monetary authorities was a policy driven by the balance of payments crisis at the end of the 1990s.

Employment and Unemployment

Statistical information in respect of this variable is scanty for the early years due to the fact that the traditional economy provided the livelihood for an overwhelming majority of the population and that the persons seeking employment opportunities in the formal market were limited in number. At the time of independence, the emerging problem of unemployment resulting from an explosive population growth was not seen as a major issue requiring policy manipulation (Rodrigo 1988). It was in the late 1950s that the problem of growing unemployment was identified as a critical policy issue (Hicks 1959, NPC 1959).

The figure refers to the depreciation of the currency during the year 2000. Between June 2000 and January 2001, the spread between buying and selling rates of the US dollar was raised at four occasions in resulting in depreciation of the currency in real terms by 13% against the US dollar. Sri Lanka 29

A series of different surveys on population and labour force that have been conducted during the past few decades could provide a general view of trends in labour force, employment and unemployment of the country.7 The available data, as summarized in Table 14, show the long-term trends in labour force participation, sectoral share of employment and unemployment. The labour force participation rate, defined as the percentage of labour force in total population, shows a significant increase during the past four decades. It accounted for 32.7% in 1963 and continued to increase up to 38.0% in 1978/79. A substantial increase in the participation rate can be observed in the 1990s, while it accounted for 50.7% in 2000. Generally this pattern of change can be attributed to the demographic trends and education policies of the country. The high rate of population growth that remained in the region of 2-3% in the 1950s and the 1960s and, the expansion of free education covering the whole population were the major underlying factors of the small labour force participation rate at the initial stages. Subsequently, the rapid decline in population growth and the rapid increase in the new entrants to the labour market resulted in a higher labour force participation rate. Table 14 Employment and Unemployment in Selected Survey Years
Sectoral share of employment as % of total Agriculturea Manufacturing Servicesb Participation Unemployment rate (%) rate (%)

1963 1971 1973 1978/79 1981/82 1986/87 1990 1992c 1994c 1996c 1998c 2000c

52.6 50.1 54.6 52.0 50.5 47.7 46.8 42.1 39.5 37.4 40.3 35.7

9.1 9.3 9.2 12.5 12.3 13.4 13.3 13.1 14.3 14.6 14.2 16.8

38.0 40.2 35.7 34.3 35.5 37.0 38.4 43.2 45.4 46.5 43.6 46.8

32.7 35.4 33.9 38.0 34.3 38.1 61.9 48.2 48.7 48.7 51.7 50.7

16.6 18.7 24.0 14.8 11.7 15.5 15.9 14.6 13.1 11.3 9.2 7.7

a: Agriculture includes forestry and fishing. b: Services include construction. c: Data exclude Northern and Eastern Provinces Source: CBSL (2000), except for 1973. Data for this year from CBSL (1973)

The change in the share of employment in production sectors corresponds to the changes in trade regimes. The share of employment in agriculture, which remained above 50% of total number employed, did not reflect a significant change in the restrictive trade regime of the 1960s and the 1970s. Even by 1981/82, it accounted for 50.5% of the total employment. The share of employment in agriculture has substantially declined in the 1980s and the 1990s. The policy reforms for trade liberalization after
In a comprehensive analysis, the information gathered from different surveys is not strictly comparable due to their differences in coverage, definitions and assessments. Nevertheless, they could provide a general picture of the trends in labour force and related variables. Sri Lanka 30
7

1977 appear to have had a significant impact on the change in employment shares in production sectors. The share of employment in manufacturing has increased from 12.5% in 1978/79 to 16.8% in 2000. However, a large part of the decline in the share of employment in agriculture has been compensated by an increase in its share in the service sector rather than the manufacturing sector. Another important feature of changing employment shares among production sectors is reflected by the corresponding changes in the share of production. The agricultural sector that has recorded a substantial reduction in its share of GDP still accounts for a significant share of employment in pointing to its low productivity improvement. The changes in the rate of unemployment correspond to the differences in growth performance between the pre-1977 restrictive trade regime and the post-1977 liberalized trade regime. Until the mid-1970s, the rate of unemployment had increased. The highest rate of unemployment in the post-independence history of the country was estimated at 24% in 1973. A distinguished feature of unemployment in Sri Lanka was the growth of unemployment of the educated youth category of the population, which is seen as an outcome of the population explosion in the 1950s and the 1960s and, the expansion of the formal education in the island at the same time (Abeyratne 1998). In contrast, the economy failed to absorb this educated youth group due to deep and prolonged economic stagnancy in an increasingly restrictive trade regime. In the second half of the 1970s, the unemployment rate declined, and was reported to be 11.7% in 1981/82; it increased to about 15% in the second half of the 1980s, when the economic performance was disrupted by the developments in macroeconomic instability and political conflicts. However, the 1990s were marked by a substantial decrease in the unemployment rate, which was estimated at 7.7% in 2000. Generally the decline in the unemployment rate in the liberalized trade regime indicates that relatively greater economic performance in the liberalized trade regime was more in line with the countrys comparative advantage than in the pre-1977 import substitution era.

Education and Health

The provision of education and health services free of charge by the government to the entire population of the country was among the priority areas of its social welfare policy in Sri Lanka. Despite the participation of the private sector in the provision of education and health care in the recent past, the governments free education and free health care policies continued to exist. Following independence, the national governments inclined to expand its welfare state in which social development received a greater priority among other economic objectives. As a result of this, during the first one and half decades after 1950, Sri Lanka experienced a rapid expansion of government expenditure on education and health as a percentage of GDP (Chart 11). The expenditure on education, which accounted for about 2.5% of GDP in 1950, increased to about 4.5% by the mid-1960s. The health expenditure as a percentage of GDP increased from around 1.5% in 1950 to above 2% in the second half of the 1950s and remained at that level throughout the 1960s. A sudden upsurge in expenditure on both education and health came in 1972, when education expenditure exceeded 5% of GDP and, health expenditure 2.5% of GDP. It is noteworthy that this unprecedented upsurge came in the backdrop of the aborted first

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youth insurrection in 1971. In the subsequent years of the mid 1970s against the external shocks and the aggravated fiscal position, education and health expenditure as a percentage of GDP reported a substantial decline. The 1980s and the 1990s were marked by education expenditure remaining in the region of 2-3% of GDP and, health expenditure in the region of 1-2% of GDP. The government expenditure on both education and health has acquired a considerable importance in the budgetary operations of the country, even though the shares of this expenditure have changed over time. In the 1950s and the 1960s, expenditure on education and health remained in the region of around 20-25% of total government expenditure, which declined to around 15% in the liberalized trade regime. Chart 11 Expenditure on Education and Health 1950-2000 (as % of GDP)
6 Percentage of GDP 5 4 3 2 1 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Education Health

Source: CBSL (2000)

In the case of Sri Lanka, what matters is not only the share of government expenditure on education and health but also the free delivery of these services over a long period of time covering the entire population. As a result, even at the early stages of the post-independence development history, the social indicators of the country remained distinct from those in most of the other developing countries. Due to innovative changes in the welfare programmes of Sri Lanka, as Sen (1988: 553-554) wrote, the 1950s were a period of sharp increases in life expectancy and of big declines in mortality rates. In the words of the architect of free education in Sri Lanka in 1943, C.W.W. Kannangara, who idealistically foresaw a classless society through free education, the best investment a country could make is for education of the people (Marga Institute 1974: 4). The result of the massive expansion in free education and free health care since the time of independence, the literacy rate was 65.4% in 1953 and increased to 91.8% in 1997 (CBSL 2000). The infant mortality rate, which was 71 per 1000 live births in 1953, declined to 16 in 1997, while the years of life expectancy has increased from 58.8 to 69.5 for males and, from 57.5 to 74.2 for females during the period of survey years 1953-91
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(CBSL 2000). These social indicators clearly show that even with a prolonged stagnant growth performance of the country combined with an explosive population growth at the time, the education and health standards of the people have been maintained and certainly improved in the subsequent period. However, all the aspects of free education, free health care and other social welfare services were not that impressive. As we analyze in the forthcoming sections, they also constituted the sources of economic, social and political problems of the country affecting the growth performance.

III. Policy Regimes and Responses

The major changes in policy regimes as well as policy outcomes have been closely linked to the frequent changes on the political front in Sri Lanka, among other things. Therefore, the differences in political and economic ideological positions of different political parties that governed the country cannot be underestimated in terms of the variations and reversals in policy regimes. The two major parties that alternated in power at regular general elections and dominated the post-independent national governments were the United National Party (UNP) formed in 1946 and the Sri Lanka Freedom Party (SLFP) formed in 1951. Being a centre-right political party, the ideological position of the UNP has always been based on the laissez-faire thinking of governance in favouring a market-friendly and private sectorled policy environment. The SLFP emerged as a centre-left party by constituting the main alternative to the UNP. The political and economic thinking of the SLFP had been in favour of a regulated and state-dominated economy and, been influenced to a great extent by socialist ideology. For the same reason, many socialist political parties, which could not form their own governments, also found room for themselves in the coalition governments formed by the SLFP. Due to the ideological discrepancies between the UNP and the SLFP, changes in governments between the two parties following regular general elections have often produced parallel shifts in development policy. However, in the course of the post-independence governance, there have been certain important changes in the ideological positions of both parties.

Policy and Political Regimes

The first national government of the post-independence period was formed in 1947 by the UNP, which remained in power until 1956 through a second general election held in 1952. Fundamentally, the period of 1948-56 seems to have been simply characterized by the continuation of the colonial free-market economy itself. Within this policy framework, the government showed its willingness to continue with the existing dualistic export economy and the expansion of the social welfare structure, built during the colonial times, and ignored the need for structural changes in the economy. Its development strategies were focused mainly on achieving self-sufficiency in agriculture. At the general elections held in 1956, a coalition of the SLFP and other minor parties, of which the SLFP was the principal partner, formed the government by ousting the UNP from power. Politically, socially and economically, the change in government in 1956 was a major turning point of the post-independence history of the country. The period was marked by a shift in development policy from a free market regime towards a

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regulated economy in which state was assigned to play the major role in development and in which import substitution industrialization received priority. A period of partial and gradual liberalization with some measures aimed at reducing the role of the government could be seen during the period 1965-70. This was necessarily an outcome of the change in government from the SLFP to a coalition headed by the UNP at the general elections held in 1965. Although the government of 1965 initiated a slow process of trade liberalization, it did not wish to change the prevalent import substitution policy framework of the country. A coalition of the SLFP and the left wing socialist parties came into power in 1970. Following the interlude of the import substitution regime under the previous UNP government, the subsequent period of 197077 witnessed an intensification of state intervention and import substitution. The UNP came into power with a landslide victory at the general elections held in 1977 and continued to remain in power through the subsequent elections until 1994. This period is important as the UNP government initiated policy reforms towards a liberalized policy regime, accompanied by political reforms to move away from the traditional political liberalism. In 1994, a coalition of government known as the Peoples Alliance (PA) headed by the SLFP came into power and managed to continue in office until 2001. In the past, the alternation in the dominant ruling party between the UNP and the SLFP had resulted in corresponding shifts in policy regimes. This tradition appears to have come to an end in 1994, as the ruling PA government continued with the liberalized policy regime established by the previous UNP government. Thus, in spite of changes on the political front, trade liberalization had now become an established policy regime, agreed on by the major political groups of Sri Lanka. The policy swings accompanied by political swings in the post-independence development history of the country are imperative in explaining the division of major policy regimes as well as the growth performance in each regime. The major shifts in the development policy, which have been linked to the changes on the political front, provide a basis for the division of the post-independence development history into major phases in the development literature of the country (Athukorala and Rajapatirana 2000, Lakshman 1997, Lakshman and Tisdell 2000). Major changes in the development strategy can be seen in 1956 and 1977, when dividing the post-independence development history of the country into three distinctive phases as 1948-1956, 1956-1977 and 1977-2000. However, the last two phases, which were longer than the first phase, have been characterized by interludes resulting in a certain degree of policy deviation from the overall patterns. The major shifts in policy regimes as well as the interludes within them were seen as driven by the economic outcome of the previous regimes too. In addition to the changes in governments, these deviations were influenced to a great extent by the internal and external shocks that the economy confronted in the respective periods. Finally, the importance of the political institutions in the country, as well as the dominant development thinking and practice in the contemporary international economic environment in influencing the changes in policy regime in Sri Lanka, as elsewhere in the developing region, cannot be overlooked. The division of the post-independence development history into three major phases can be justified even by the distinct features of economic performance in each of the phases. Against the colonial open economic policy during the first phase of 194856, the economy enjoyed moderate growth performance and healthy macroeconomic

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stability, owing to the contemporary economic prosperity and the commodity booms in the world market favouring the countrys primary exports. Generally, the second phase of 1956-77 was marked by lower growth performance and aggravated macroeconomic imbalances, which were kept under control by gradually tightened regulations in an increasingly restrictive trade regime. However, the decade of the 1960s can be considered as the initial phase of the import substitution regime, where growth performance and manufacturing expansion show an upward trend, facilitated by the exploitation of initial import substitution opportunities. The upward trend in growth performance came to an end during 1970-1977, when easy import substitution opportunities started drying up and, when the economy started moving towards a highly restrictive trade regime. The growth performance was generally higher during the third phase of 1977-2000 under the liberalized trade regime, which was nevertheless characterized by worsened macroeconomic imbalances.

1948-1956: Continuation of the Colonial Economy

Although political independence in many countries in Asia had been accompanied by significant changes in their development strategy aimed at restructuring the colonial economy, this was not the case in Sri Lanka. The policy orientation of the first national government of the UNP, in contrast to the normal pattern in Asia, was to continue with the colonial status quo in respect of the economic structure, with little emphasis on manufacturing growth. As Oliver (1957) argued, the economic policy during the period of 1948-1952 was little different to that of the Colonial State Council era. Free trade policies The colonial policy regime was based on the principles of free-market economy with special provisions made in respect of the countrys relationships with the United Kingdom. International trade was virtually free, while minimal controls on import trade and foreign exchange payments were applied to international transactions with countries outside the Sterling Area. As was the case during the colonial period, preferential treatment was accorded to trade with the United Kingdom. On average, the import duty as a percentage of the value of imports accounted for 16% in 1947/48 and increased only up to 19% by 1955/56 (Snodgrass 1966: 190). The main objective of the use of commercial policy measures was maintaining the government revenue. Sri Lanka continued with a system of fixed exchange rate pegged to the Sterling Pound under the Bretton Woods system. The currency was fully convertible with the Sterling Pound through its link with the Indian Rupee. Nevertheless, until 1949 the foreign exchange market was not free (CBSL 1998). A change in the exchange rate of the Sri Lankan Rupee was not possible as long as the exchange rate between the Sterling Pound and the Indian Rupee remained unchanged. In addition, there were restrictions imposed on US Dollar expenditure in discouraging transactions with Dollar Areas against those with Sterling Areas. Under the Currency Amendment Act of 1949, Sri Lanka gained flexibility to determine its own exchange rate. Thus, in response to the devaluation of the Sterling Pound in 1949, Sri Lanka devalued its currency by 30% against the US Dollar with a view of stimulating exports to the Dollar Area. However, the close link of Sri Lankas exchange rate to the Sterling Pound continued, while its cross rate with the US Dollar was determined by the Sterling-Dollar exchange rate.

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Industrial and agricultural policies The development ideology of the UNP government after independence was also not in favour of an industrialization process in any direction, which could have otherwise aimed at changing the colonial economic structure. As Oliver (1957) noted, there was much concern about the need for industrialization at policy levels, but in reality the government placed little emphasis on industrialization. It also faced the problem of continuing with existing state-owned inefficient manufacturing enterprises that had emerged during the period of the Second World War. In fact, a number of these inefficient industrial ventures were closed down. Although the government introduced a modest programme to revamp some of the state-owned industrial activities, the commercial failure of most of the undertakings resulted in a gradual disengagement of the state from commercial and industrial ventures (Athukorala and Jayasuriya 1994: 9). Under the market-oriented economic policy, the UNP government was in favour of allowing the private sector to play a major role in manufacturing development. Nevertheless, an industrial capitalist class had not yet emerged to undertake this task. The private sector, which made a marginal contribution to the growth of savings and investments in general and to the accumulation of industrial capital in particular, concentrated more on plantation and related trading and commercial activities than on manufacturing, as a heritage of the colonial legacy. In contrast to the governments attitude towards industrialization, its development strategy was strongly directed at agricultural development with a view of reviving the countrys ancient self-sufficient agricultural economy.8 The government took initiatives to allocate a large part of public investment in agricultural development. According to the Six-Year Development Plan (1951-57), the government had estimated to allocate 28.1% of total investment funds in agriculture in contrast to 6.3% in industry.9 The agricultural development strategy consisted of rehabilitation of the irrigation systems, colonization of abandoned agricultural land and, a programme for resettlement of farmers by reducing the population pressure in the South. Political economy of the development strategy The retention of the colonial economic structure even after gaining independence was dictated by both economic and political factors. The UNP that formed the first postindependence government largely represented the interests of the countrys elite groups who wished to see the continuation of the export economy inherited from the colonial past (Lakshman 1997). The leaders of the UNP itself, including the Prime Minister D.S. Senanayake, were close associates of the British rulers and shared power with the British in the colonial State Council. The political leadership, based as it was on plantation and related commercial interests, was ideologically comfortable with the existing economic
Due to the shift of the Sinhala kingdoms from the North-Central region to the South and the negligence of domestic agriculture during the colonial period, the agricultural prosperity of the country had faded away and the main agricultural zone in and around the North-Central region had been sparsely populated. In addition, due to the land encroachment policy of the colonial government since the mid-nineteenth century for the plantations, the indigenous peasantry had lost common agricultural land (Alailima 2000). This was an acute problem at the time, which called for state-aided settlement schemes and agricultural development programmes. 9 The figures refer to the revised estimates of the plan in 1952. According to the original estimates in 1950, the estimated amount of public investment was 37% in agriculture and 5.5% in industry (IBRD 1953: 107). Sri Lanka 36
8

status of the country (Wickremeratne 1977). Apparently, the need for structural change in the economy did not arise immediately because of the contemporary economic prosperity. Therefore, on the part of the policy makers it was difficult to see any urgency for restructuring the economy at the time. The policy priorities of the first government were strongly influenced by the perception that the countrys economic development should be based on self-sufficiency in agricultural production. Since the 1930s, the leaders of the UNP were strong proponents of reviving domestic food crop agriculture (Athukorala and Jayasuriya 1994). Besides, this perception was not ungrounded, as the country had lost its ancient agricultural self-sufficiency during the colonial time and had become more and more dependent on the importation of food for domestic consumption. The need to promote production of paddy arose mainly due to the heavy import bill on account of rice, of which about half of the domestic consumption demand was satisfied through imports in the 1950s (CBSL 1998). Consequently, as Oliver (1957: 66) wrote, there was a constant and greater involvement of the government in agricultural than in industrial problems. The external advice that the policy makers received at the time was in line with their own perception. The World Bank Mission that visited Sri Lanka in 1951 found that given the limited availability of resources in Sri Lanka, such as capital, management, technology and skilled labour, manufacturing development was not yet possible (IBRD 1953). The Mission urged that, given the current stage of development of the country, priority should be given to maximization of agricultural production by improving efficiency and opening up new land. This policy priority was also consistent with the politically appealing landless problem of the peasantry. The opposition of the ruling UNP at the time - the left-wing political parties, was much in favour of industrialization. Their interests and activities must have had a bearing impact on the governments ideological position on economic development. Although there was much concern about the need for industrialization, the conservative political leadership feared that it would strengthen the working class movement backed by leftists (Wickremaratne 1977). The leftists, who were involved in organizing society along their ideological lines since the early twentieth century, had already grown in strength and influence particularly in the plantation and urban sectors. Some of the early actions of the UNP government curtailed the potential electoral victory of the leftists in the plantation areas.10 However, the government was confronted with a series of widespread working class and peasant unrest organized largely with the support of the left-wing political parties (Jayawardena 1990). The government hoped to ease the growing unrest through agricultural development together with an expansion of social welfare. A strong commitment to an element of social welfare was needed for political survival in a society used to basic measures of such a social welfare system. It had also been seen as an important strategy of maintaining social peace, containing leftist political influence, and attracting the votes at the general elections (Alailima 1997, Athukorala and Jayasuriya 1994, Dunham and Jayasuriya 2000, Marga Institute 1974). The economic
The conservative UNP government, which was looking for avenues to suppress the political expansion of the leftists in the plantation areas, denied Citizenship to Indian Tamils, who dominated the plantation sector, and dis-enfranchichized the majority of them immediately after independence through a number of Acts passed in the parliament: Ceylon Citizenship Act of 1948, Indian and Pakistani Residents Act of 1949 and, the Parliamentary Elections Amendment Act of 1949. The first two Acts denied the citizenship to the majority of Indian Tamils, while the third restricted the voting rights of the non-citizens. Sri Lanka 37
10

hardship of the masses during the Depression in the 1930s and the Second World War in the 1940s, provided fertile ground for the leftists to grow as the main alternative political force to the conservatives that formed the UNP. In order to contain the growing strength of the leftists, who were the proponents of social welfare, the conservatives who shared power in the colonial State Council exerted pressure on British rulers to initiate a series of welfare measures in the form of free health, free education and consumer subsidies. The UNP government after independence retained and, of course, expanded the welfare state inherited from the colonial past, although this policy had a bearing impact on the deteriorating trade balance and the growing fiscal burden. Policy outcome The UNP era of 1948-1956 was characterized by a regime of mild policies within a free-market economy, compared to those that succeeded it subsequently. However, it set the parameters of Sri Lankas distinctive features of the post-independence development process as well as for economic, social and political issues leading to radical changes in the policy regime that were due to come. The UNP regime opened up avenues for major criticisms that were centered on the fact that it did not bring about any significant changes in the colonial economy. These criticisms were seen as applied not only to economic issues but also to social and political issues, which altogether set the conditions for giving birth to a new regime in 1956. The UNP government failed to bring about any significant policy-induced growth performance of the country. The higher growth of real GDP in 1951 and in 1955 could be attributed to the price booms in the world market. With rapidly growing population at the time, as Snodgrass (1999: 94) noted, by the time the UNP was swept away from office[in 1956], GNP per capita was not very different from what it had been in 1948. Even the governments major development strategy for self-sufficiency in agriculture was inadequate to achieve a growth momentum in GDP or a reduction in import bill of foodstuff. As Oliver (1957: 74) pointed out, production data do not supply full information with respect to yields, but agricultural development obviously lagged far behind ambitions. Even though agriculture received policy priority, it continued to be treated as the subsistence sector of which the achievement of self-sufficiency would save foreign exchange, spent on importing foodstuffs. Moreover, the governments massive subsidy programmes in food consumption were in conflict with its own objective of promoting agriculture. The largest food subsidy was on the consumer purchases of rice, which was introduced during the Second World War under a ration system covering the whole population. Although the war was over, the subsidized rice ration system continued without any economic rationale well over three decades until it was abolished in 1978. Against the export price boom in 1950/51, the government increased the subsidy on rice and expanded it to cover consumer purchases of wheat flour as well. This was done against the second parliamentary election that was due to come in 1952. Perhaps, the action was proven to be strategically right by the election results, which gave the UNP an opportunity to be in office for a second term. However, since 1952 export prices were declining while import prices rose. Imported rice cost more than three times its subsidized price in the domestic market worsening the fiscal burden of the government (Athukorala and Jayasuriya 1994: 8). In this context, the government found no other alternative than reducing the consumer subsidies on goods

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and services, including a reduction in rice subsidy in 1953. The decision resulted in a widespread and massive political reaction in the form of a violent protest and a general strike backed by the left-wing political parties. The incidence forced the Prime Minister, Dudley Senanayake (the son of the former Premier D.S. Senanayake), to resign and the government to reverse the action by increasing the rice subsidy and enlarging its portion of ration. It provided a crucial early lesson for the political parties that were involved in a constant competition for power to use the social welfare system as a weapon to gain popularity and to defeat the rivals. Therefore, the incidence was important not for its immediate repercussions on the governments fiscal operations, but for its long-term impact on conditioning the rules of the game in economic and political future of the country. The economic performance in the 1950s was characterized by the disproportionate buoyancy of consumption fed by export price booms. These booms have produced a kind of irreversible ratchet effect on aggregate consumption expenditures so that the strong upsurge in income in the boom years was followed by an equally strong rise in consumption (Snodgrass 1966: 184). As a result of the trickle-down effect of the prosperity arising from the commodity booms, real wages increased rapidly in the first half of the 1950s (CBSL 1998). Although the booms had come to an end and the growth performance became sluggish, the consumption was still rising. Therefore, personal savings as a percentage of disposable income, which remained low at 7.5% in 1950, recorded a constant decline and did not even reach that low level again in that decade (Snodgrass 1966: 185). Alternatively, private investment should have risen. As the Minister of Finance of the first government pointed out, investment by the private sector of the economy has, in the recent past, always been small if not negligible (Ministry of Finance 1951: 38). Since the increase in income against the commodity booms was absorbed by consumption, which is downward rigid, it was difficult to see any significant improvement in investment by the private sector. The government, trapped with an inescapable social welfare system and the need for maintaining its current expenditure on goods and services, was faced with difficulties in raising public savings and investment. The revenue system inherited from the colonial past was heavily dependent on indirect taxes levied largely on import and export trade. Therefore, the government revenue was fluctuating largely in response to the external shocks affecting the countrys international trade. During the price booms the government experienced a sound fiscal position, which resulted in a substantial increase in current expenditure in general and its welfare expenditure in particular. Therefore, during the first phase of 1948-56 neither the private sector nor the public sector was able to contribute sufficiently to lay the foundation for achieving sustainable growth momentum. A political vacuum The regime experienced social and political problems due to a vacuum between the vested interests of the ruling UNP and those of the majority of the indigenous population. The UNP represented the interests of the Westernized elite groups of the country, based on the colonial economic foundation. It was closely associated with the former colonial ruler, the United Kingdom, and other countries of the Western capitalist bloc. The majority of the indigenous population was still left in the subsistence agricultural

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economy in the rural areas even after the independence, as was the case during the colonial past. A large majority of this population comprised Sinhala-Buddhists, who believed themselves to have lost their due social status during the colonial times and who were still found to be deprived against the dominant Westernized minority elite groups. Independence had brought about resurgence in Sinhala-Buddhist nationalism, which was backed by contemporary national movements such as the Buddhist revival, anti-Christian and temperance movements, which had come into being in the nineteenth century (Jayawardena 1990). Nevertheless, until 1951, the resurgence of Sinhala Buddhist nationalism did not have a major political force to represent the interests and to address the grievances of the majority of the indigenous people as neither the UNP nor the leftists filled the vacuum. A faction of the UNP government led by one of the Cabinet Ministers, S.W.R.D. Bandaranaike, who left the government and formed the SLFP in 1951, grabbed this opportunity created by the civil society. Neither the governments agricultural development strategy nor its political commitment to social welfare was strong enough to save the UNP government at the general elections in 1956. A party coalition named Mahajana Eksath Peramuna (MEP: Peoples United Front), of which the SLFP was the major partner, won the 1956 elections on the waves of an anti-Western, anti-Christian and Sinhala-Buddhist political resurgence.11 The emergence of the SLFP and its victory in 1956 was important because not only it ousted the UNP from power but also relegated the traditional left-wing parties that so far constituted the major alternative political force to the UNP.

1956-1977: Closing up of the Economy

The period of 1956-1977 was marked by a shift in development thinking and policy from one of free market towards a regulated economy in which the state was assigned to play the major role in economic development and in which import substitution industrialization received priority. Generally, there was a gradual intensification of state intervention in the economy and of import substitution trade strategy from the beginning to the end of the period. However, certain deviations can be seen within the overall policy framework, which coincided with changes on the political front. These deviations were seen as governed by the contemporary issues confronted by the respective governments as well as by the economic and political ideology of the ruling parties that changed frequently at the general elections. 1956-1959: The shift in policy focus Having the SLFP as the major partner, the MEP government remained in power for four years (1956-1959). Although the SLFP was not committed to socialism per se, it did not oppose to add elements of socialist economic philosophy such as central development planning, nationalization of foreign ventures, state enterprising in basic industries and in key areas of the service sector. In fact, the government received the support of the Soviet
This indigenous political force on which the power of the new government was based came to be known as the five-fold great force comprising Buddhist monks, indigenous physicians, teachers, farmers and workers. Also the year 1956 was a special one. The victory of the MEP on Sinhala Buddhist nationalism in the year coincided with Buddha Jayanthi in the same year, which marked 2500 years of Buddhism. This particular event, which was celebrated by Buddhists throughout the world, strengthened the local appeal for the restoration of the lost status of the Sinhala Buddhists. Sri Lanka 40
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bloc, which was seen at the time as a successful case of import substitution industrialization and, for that matter inspired by the development policy of neighbouring India. With a rapidly growing population and an aggravating unemployment problem, the danger of the dependence of the economy on plantation sector and subsistence agriculture received policy attention. Besides, the symptoms of a possible end to Sri Lankas initial prosperity based on the plantation exports were already evident. It was the time that import substitution strategies based on the theoretical premises built on the Structuralist perspectives increasingly attracted the newly independent states, which were eager to change their colonial economic and political image in general and, the production and trade patterns in particular. The development strategy of the MEP government laid greater emphasis explicitly on industrialization along import substitution lines (NPC 1959). The lack of private capital and entrepreneurship in the classical colonial economy provided a justification for the policy emphasis on state capital and state-owned enterprise in its industrial strategy. The new economic and political orientation of the MEP government was rather consistent with the nationalist sentiment of the Sri Lankan society as elsewhere in newly independent states. All ranks of Ceylonese politicians and writers, from conservative to communist, have shared this nationalist emphasis in economic opinion. (Oliver 1957: 13). The development strategy outlined by the MEP government was welcomed by the political forces on which its power was based, i.e., the non-Westernized Sinhala-Buddhist social groups who were mostly absent in the modern plantation, trade and commercial sectors. The new policies restricted the non-Sinhala control in these areas on the economy and provided an opportunity for indigenous social groups to emerge and integrate with the modern economy. The leftists also favoured the new policy and political orientation on their part because, in principle, they opposed the capitalist influence of the Western bloc and emphasized the need for industrialization. The regime, which was characterized by more preparation than implementation of the new policies, experienced sluggish growth performance and worsening external and internal balances. Even politically it was a troublesome period as prolonged strikes and ethnic tensions disrupted the regime, which ended with the assassination of the Prime Minister, S.W.R.D. Bandaranaike in 1959. The new government that came into power in 1960 was the SLFP headed by Sirimavo Bandaranaike (the widow of the former Premier) who became the Prime Minister of the new government.12 1960-1965: Foreign exchange problem and import controls The most critical issue that the new government had to face immediately was the foreign exchange problem. The trade balance, which had already turned into a deficit, accounted for the highest amount of deficit in 1960 (US$ 44 million), the highest ever reported in the past. The amount of external assets was less than half of that reported five years ago in 1955. The period started with increased tariffs and quantitative restrictions on imports
12

The assassination of the Prime Minister in November 1959, created chaos in the political front until the SLFP led by his widow came into power in July 1960. A caretaker government took office for a few months and held elections in March 1960. Although the UNP through alliances with small parties could form the government at this election, it was easily fragile, as it did not have the required parliamentary majority. Although the UNP attempted to strengthen its position by enlarging the rice subsidies, this action did not save the government, which lasted only a few weeks. 41

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and controls over foreign exchange, designed to meet the growing foreign exchange crisis. First, the Central Bank announced selective credit controls in 1960 to reduce imports of non-essential goods. Then, an increase in tariff rates with expanded commodity coverage resulted in a highly differentiated tariff structure, which comprised ad valorem rates ranging from a minimum of 10% to a maximum of 500%. This was followed by an imposition of 5% surcharge on all imports other than on foodstuffs in 1961. In the same year, the government banned imports of 49 items classified as luxury goods, and introduced licensing requirements for most other imports. By 1962 all imports, except foodstuffs, petroleum, fertilizer and pharmaceuticals were subject to quantitative restrictions. With all restrictions on imports, there was still an excess demand for foreign exchange, which was met by drawing upon external reserves in the absence of sufficient foreign capital inflows. Therefore, the external reserve position deteriorated further, compelling the government to tighten foreign exchange controls. A Foreign Exchange Budget Committee was set up in 1963 with the assigned task of allocating the available scarce foreign exchange on the basis of a system of priorities. Next year, the foreign exchange controls were expanded further to cover repatriation of profits and dividends, overseas education and foreign travel. Trade restrictions of the 1960-65 period induced import substitution production, particularly in manufacturing as most of the high tariffs and quantitative restrictions were applied on imports of the respective manufactured commodities. In fact, the tariff rates were highly differentiated according to the degree of competition a particular import would offer to domestically produced substitutes (Rajapatirana 1988). Therefore, the import controls, though initiated primarily in response to the foreign exchange problem, had the twin objectives of exerting control over trade balance and providing protection to domestic producers. Apart from the inducement for the production of import substitutes given by import controls, the government emphasized the need for import substitution production in both public and private sectors. A wide range of incentives for the private sector was announced in 1961. Some of the policy measures included tax concessions, depreciation allowances on machinery, concessionary duties on imports of producer goods, technical assistance and credit facilities (CBSL 1998). The governments direct involvement in industry was expanded with an increase in public resources allocated to state-owned industries and setting up of public sector industrial corporations with the assistance of the Soviet bloc. Although the government had announced a policy package for attracting foreign investment in its first Budget Speech for 1960/61, there was a virtual boycott of the country by foreign capital. The restrictive trade regime resulting from controls over imports and foreign exchange was not conducive to FDI flows. In addition, it was futile to anticipate FDI flows in a regime characterized by nationalization of the private and foreign business ventures. During the period of 1959-64, the former MEP government and the now SLFP government had completed the nationalization of a number of large business ventures such as the public transport, cargo handling in the port, oil companies, banking and insurance. There is little doubt that the ideological position of the SLFP favouring industrialization along import substitution lines generally provided blanket coverage for the economic policies adopted during 1960-65. Nevertheless, the drastic move towards a

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restrictive trade regime was an outcome of complex economic and political factors, which were in operation at the time. Although controls over imports and foreign exchange payments were initially adopted as an immediate remedy to the foreign exchange crisis, as the problem worsened the government was inclined to tighten these controls assuming that the resultant increase in import substitution production would ease the external and internal imbalances. By exhibiting the political weakness of the SLFP government, it was not willing to make drastic cuts in public expenditure in response to the balance of payments problem (Athukorala and Jayasuriya 1994). Obviously, this action would have involved such unpopular measures as cut backs in consumer subsidies leading to a political risk. An important event in this respect was the proposal put forwarded by the Minister of Finance to reduce the national rice subsidy to ease the budget deficit of the government. The decision provoked the trade unions and left-wing parties compelling the government to withdraw the proposal and the Minister of Finance to resign. Thus, expenditure on food subsidies, which accounted for 10.6% of total government expenditure in 1959/60, increased to 12.9% by 1964/65 (Table 10). In order to meet the large budget deficit, the government resorted to a nationalization programme that was also consistent with the political ideology of the trade unions and the left-wing parties. The government also entered into an alliance with the major left-wing parties by averting strategically the militant trade union protest supported by the left-wing parties in 1964. 1965-1970: Mini liberalization and export promotion The general election in 1965 was of particular importance, as it did not result in a significant majority to any party in the parliament. Although the SLFP-led coalition won the majority of seats, the UNP together with the Tamil and other minor parties outnumbered it and formed the government. The pro-Western policy stance of the new government led to a revival of development assistance from the Western countries and strengthening of the confidence of financial institutions including the IMF (Athukorala and Jayasuriya 1994). Even though the new government was reluctant to make a radical change in the existing import substitution policy framework, the period of 1965-70 was marked by a partial deviation from the previous closed economy model. It was characterized by a moderate liberalization of import trade and foreign exchange payments, initiation of some export promotion policies, an attempt to restrict state intervention in economic activities, and a resurgence of policy emphasis on import substitution in agriculture. Allowing the private sector to take its due place in industrial development, de-prioritization of the previous state-led industrialization was apparent in the new policy. Overall, the policy move was in line with the UNPs own ideological stance. However, it appeared to opt for a cautious, selective and gradual trade liberalization programme in which some of the important policy measures came into effect not immediately but in the latter part of 196570. After coming to the office, the immediate focus of the government was on the relaxation of import controls and restrictions on foreign exchange payments. In 1965, tariffs on a range of consumer goods including foodstuffs, textiles and petroleum products were abolished with the view of eliminating the supply shortage and bringing down the cost of living. This period acquires significance in respect of its application of

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certain novel measures for the promotion of non-traditional exports, i.e., exports other than those of tea, rubber and coconut. One of the specific incentives granted to non-traditional exports in the early period was the introduction of the Bonus Voucher Scheme (BVS) in 1966. Under this scheme, the exporters of specified non-traditional goods were provided with an import entitlement quota to the value of 20% of export earnings. Under the existing import control system, the market price of BVS quota, which provided an implicit export subsidy to the exporters of non-traditional goods, was high and fluctuated with changes in import controls (Dahanayake 1977). Import controls were relaxed further in 1968 with the elimination of the quantitative restrictions on the bulk of imports, which were brought under the Open General License (OGL) system. As a result of the relaxation of import controls, immediately and naturally there was an unprecedented increase in trade deficit. In the face of worsening balance of payments conditions in the first years of this period, the government took two important policy measures in respect of the exchange rate policy as part of a stand-by agreement entered into with the IMF. The first was the nominal devaluation of the Sri Lankan Rupee by 20% in 1967 against the intervention currency, the Sterling Pound (CBSL 1967).13 The second measure of the exchange rate policy was the replacement of the unified exchange rate system with a dual exchange rate system under the Foreign Exchange Entitlement Certificate (FEEC) system introduced in 1968 (CBSL 1968). At the beginning, the special rate of foreign exchange was set at 44% above its official rate,14 and was applied to non-traditional exports and non-essential imports. Thus, the FEEC system provided a cash incentive to non-traditional exports and imposed an additional cost on non-essential imports through the application of the special exchange rate in respect of such transactions. Interestingly, import substitution in agriculture rather than in industry again received priority in the policy agenda of the government of 1965-70. The policies were directed at increasing production and productivity of rice as well as other food crops through introducing high-yielding varieties, agricultural credit schemes, guaranteed price system, extension services, fiscal incentives and institutional reforms. The policy priority in agriculture development was consistent with the UNPs own development ideology since its inception, as was evident in its earlier policy regime of 1947-56. However, the new developments in the 1960s have contributed to the revival of this policy stance. At a time of worsening trade balance, it was natural that the heavy concentration of import expenditure in food items attracted policy attention. The period from 1960 onwards was marked by a sharp increase in the share of foodstuffs in total imports. The foreign exchange shortage was the major bottleneck in respect of meeting essential food
13

This was partly a response to the devaluation of the Sterling Pound by 14.3% against the US Dollar in that year. Although the currency devaluation in 1967 was a radical policy measure at the time, the policy was seen as inadequate to bring about any substantial change in relative prices of imports and exports. Allowing for the devaluation of the Sterling Pound, the rate of devaluation of the Sri Lankan Rupee was only 5.7% in net terms, which was not sufficient to set domestic prices in line with the scarcity value of foreign exchange (Dahanayake 1977: 113). 14 In the original proposal, the special rate was meant to be a floating rate, determined by the tenders for the FEECs in the market. The premium price was expected to vary in response to demand for and supply of the FEECs. However, it was administratively set at SLRs. 44.00 per certificate with a face value of SLRs. 100.00 and continued with that system during the operation of the system (Dahanayake 1977). Sri Lanka 44

requirements of the country. In addition, the contemporary worldwide agriculture movement, reflected in the Green Revolution, had its impact on the Sri Lankan policy thinking as well. Even in a moderately liberalized trade regime, the growth performance in 1965-70 was higher than that in the previous period since independence, save high rates of growth in the price boom years. Moreover, it shows an upward trend with the peak point reported in 1968 recording 8.2% of GDP growth fueled by a massive upward swing in terms of trade. In the subsequent two years, growth slowed down in the midst of a sharp decline in terms of trade. However, the ambitious export promotion and agricultural development fell far short of the requirements to relieve the balance of payments problem. The expenditure on imports that recorded a forceful decline during the previous regime of 1960-65 increased rapidly at an annual rate of 11.3%, which was significantly higher than the growth of exports at an annual rate of 1.5% during the period 1965-70 (Abeyratne 1997: 356). The policy makers of the 1965-70 regime apparently felt that Sri Lankas external imbalances could be rectified in the short-run with adjustments on the import side as export earnings could be increased by increased production, which would take time (Corea 1971). Particularly for this reason, justified by the then dominant development perspectives favouring import substitution, the government was hesitant in bringing about a radical trade liberalization policy, which would have disrupted the existing import substitution trade regime. Policy dilemma The government appears to have suffered from the lack of political strength required for a programme of full-scale liberalization mainly for two reasons. First, although liberalization was consistent with the UNPs own ideological position, the world development thinking, which conditioned the contemporary development practices in most of the developing countries, was against it. If the government had initiated a fullscale liberalization programme in 1965, it would have been a radical and risky exercise at a time when world development thinking and practice were against such a policy stance. Secondly, the potential political resistance that it would have produced otherwise weakened the political will and the capacity of the government for liberalization. Apparently, the potential political opposition as such would have been fully backed by the opposition SLFP and the left-wing parties of which the ideological lines were in favour of a regulated economy. It would have been most likely that the government expected that the positive outcome of export promotion and agricultural development would pave the way for a gradual move towards a liberalized trade regime by averting its short-term cost of adjustment. However, this expectation was not realized, as the overall outcome of policy within a given short period of time was not satisfactory. As the balance of payments outcome during 1965-70 was disappointing, the government was dependent on external sources of financing. In fact, the government had a White Paper on Foreign Investment issued in 1966 with an attractive incentive package to foreign investors. It was under this government that the role of FDI in export promotion received official recognition for the first time (Athukorala 1997). Yet within the existing import substitution policy framework, this was inadequate to produce much by way of achievement. Therefore, the period witnessed an increased reliance on foreign aid and loans on which Sri Lankan governments had a pessimistic view since independence. As the commitments for concessionary assistance fell far short of excess

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demand for foreign exchange in the latter half of the 1960s, there was an increased dependence on commercial borrowings, which added a new dimension to the countrys policy concern, i.e., foreign debt burden. Foreign debt, as a percentage of GDP reached double-digit level in 1968, and increased further in 1969, when the next general elections in 1970 were getting close. The general elections in 1970 resulted in a landslide victory to a coalition of the SLFP and the dominant left-wing parties of the time, the LSSP and the CP and, marked the end of the five-year mini liberalization process. It was an interesting question, however, why such a government that took steps to relieve the economic hardship of the masses resulting from severe import controls, and one that adhered to the promotion of rural agriculture on which the majority of the population was dependent, was ousted from power by the electorate. This was the price that the UNP government had to pay for attacking consumer subsidies,15 as was spotted by the then Prime Minister himself, Dudley Senanayake, after his defeat. For him, this was the second defeat during his political career taking into account the first defeat in 1953 for the same reason. 1970-1977: Import substitution in a controlled economy In spite of their conflicting interests, there was a common framework for unity between the SLFP and the major leftist parties, which formed the United Front (UF) government in 1970. The LSSP and the CP had now clearly understood that there would be no opportunity for them to form their own socialist government in the Sri Lankan political arena, as their due place was grabbed by the SLFP. At least two factors were imperative for them to find room for alliance with the SLFP. First, a unity among the centre-left and left-wing parties was the clear way of defeating their common enemy, the UNP. Secondly, being a centre-left reformist party, the SLFP to a great extent had the capacity to allow the leftists put forward their programme into action towards a socialist economy. The first Budget Speech of the UF government in 1970, delivered by the then Finance Minister N.M. Perera (the leader of the LSSP) clearly stated the objective of the UF government to lay the foundation for the building up of a socialist society in Sri Lanka. The regime under the UF government was indeed a period of radical changes in development strategy and of economic and political crises. Radical changes in development strategy were brought about by the reversal of liberalization attempt of the previous regime with tightened import substitution policies and stringent government control over the economy. This was combined with stringent measures adopted to achieve redistributive justice and, in most of the cases they were also in conflict with the growth objective. Overall, the measures adopted by the UF government in the face of the economic crisis compelled the public to undergo the severest economic hardship that they had ever experienced in the post-independence history. Even though the policies were consistent with the ideological base of the UF coalition, there were two major factors, which influenced or more precisely strengthened the policy-making in the 1970-77 regime.
For the first time in the post-independent history, the UNP government succeeded in reducing the quantity of rice provided on weekly ration from 4 pounds per person at SLRs. 0.50 each to 2 pounds free and 2 pounds at market price of about SLRs. 2.00 per pound. This was subsequently followed by further reductions in subsidies on rice and other foodstuffs provided on ration. Sri Lanka 46
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The first was the insurrection in 1971 that the UF government had to face within less than a year after coming to the office. The insurrection was led by the clandestine Janatha Vimukti Peramuna (JVP Peoples Liberation Front) that attracted youth from the Sinhala community. Although the JVP had a revolutionary leftist ideological basis, it was rooted more in the rural peasantry than in the modern industrial working class (Moore 1993). It was recognized that the JVP insurrection was led by the frustration and resentment of the educated rural youth coming from more depressed social classes in the majority Sinhala community (Obeyesekere 1974). Therefore, the insurrection had an overwhelming impact on the UF governments concern over redistributive justice and its march towards a socialist economy. The insurrection was immediately followed by intensified nationalization programmes, land reforms including the distribution of large estates among rural farmers, employment creation in the public sector, and education policy reforms for equal distribution of opportunities for university education. However, the redistributive justice made little sense in a stagnant economy when there was so little to distribute. The second was the oil shock in 1973 that led the UF government to intensify its trade restrictions and distributive policies in order to face the consequent balance of payments problems and fiscal deficits. This was the first unfavourable external shock that had ever occurred in such a magnitude in more than doubling the import expenditure by 1975. In the context of the already weakened economic performance in the years prior to 1973 (due to youth insurrection and bad weather conditions), with the oil shock the government was left with no option other than stringent controls to save the internal and external balances. Trade and Exchange Rate Policies Immediately after coming to power, the UF government tightened import controls and restrictions on foreign exchange payments with the view of achieving the twin objectives of relieving the balance of payments deficit and protecting import substitution industries. The government viewed the liberalization attempt of the former government as a wasteful experiment, in which valuable foreign exchange was allowed to be squandered on non-essential imports (Rajapatirana 1988). The OGL system was abolished in bringing all imports under individual license and a quota system in 1970. A six-band tariff schedule was introduced in 1971 with tariff rates ranging from a 5% nominal rate to a 150% prohibitive rate. However, the tariffs were mostly ineffective as the imports were subject to the quantitative restrictions and, the importation of most items categorized as essential was brought under state monopoly. In addition to the tightened control over foreign exchange payments, the Exchange Control Act of 1971 imposed a series of restrictions on the acquisition, maintenance and transaction of assets. The oil crisis in 1973 and the resulting additional burden on balance of payments compelled the government to tighten exchange controls further. Highly restrictive controls were introduced for both current and capital account transactions, which continued to remain until 1977. Although the main development strategy fell within an import substitution policy framework, export promotion strategies initiated in the previous trade regime continued to have a place in the 1970-77 policy agenda as well. As it was expected at policy level, import substitution combined with export diversification would enable the economy to escape the crisis. The government placed a greater reliance on the FEEC system of which the special premium was raised to 65% above the official exchange rate in 1972. In the

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context of an overvalued exchange rate regime, this increased the cash incentive to nontraditional exports. Although it resulted in an increase in the cost of non-essential imports as well, the complex system of import controls established by quantitative restrictions and foreign exchange controls plus high tariffs had already made it unnecessary. In addition to the revisions in the FEEC system, the government introduced another export-promoting measure, known as the Convertible Rupee Account (CRA), in 1973 to provide further incentives to the exporters of non-traditional goods (CBSL: 1973). The exporters of non-traditional goods were allowed to maintain 25% of their export earnings in CRAs that could be used to finance specified restricted imports and other payments in foreign exchange. In addition, fiscal incentives were granted to the exporters of non-traditional goods, while institutional facilities for export promotion were provided by setting up those institutes such as the Export Promotion Council, the State Gem Corporation, and the Department of Minor Export Crops. The role of the government Just as import controls were reaching their heights in the 1970s, the regime was marked by an unprecedented expansion of the government over the private sector. The government expanded its role covering all forms of economic activities, being the major entrepreneur and, regulating the economic activities of the private sector, being the major provider. Although the private sector was provided with heavy protection for import substitution production and incentives for export diversification, the principle message that the UF government delivered to the private sector was a different one. State capital and entrepreneurship in industry, agriculture, distribution, trade, commerce and other key service sectors became major components of the new role of the government. The government viewed that heavy, basic and essential industries should be under either state-ownership or some other form of state control, although the role of the government was not confined to industry alone. The Business Undertakings (Acquisition) Act of 1970 provided the government with the necessary powers to take over any business activity that was considered to be in the national interest and that had more than 100 employees. There is little doubt that this Act produced serious adverse effects on industrial expansion in the private sector. During the period until 1977, 26 business ventures were converted into government-owned business undertakings (Athukorala and Jayasuriya 1994: 19). Under the Land Reform Act of 1972, which imposed a land ceiling of 50 acres per individual, large plantation estates came under state ownership. The programme was extended further in nationalizing the foreign-owned plantation sector as well. Consequently, industrial and service enterprises in the public sector increased in number and size, while there was a relative contraction of the private sector including the multinational corporations (Kelegama and Wignaraja 1991). For instance, by 1977, the state owned enterprises accounted for over 60% of manufacturing value added and 50% of employment in manufacturing (Athukorala and Rajapatirana 2000: 80). The government expanded its role by acting as the main provider of basic necessities of public life. The popular welfare services including free health care, free education and a consumer subsidy system were already a major and inescapable responsibility of the government. In respect of the provision of basic consumer goods and services, market had little role to play because they were subject to price controls, state monopoly and a system of distribution on ration. The government undertook the responsibility of importing most of the basic consumer goods under state monopoly. The

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Paddy Marketing Board, which was established in 1971, was assigned the monopoly status to purchase paddy from domestic producers. The public cooperative shops, which were spread throughout the country, played a major role in purchasing, marketing and implementing the ration system. Continuous drought in the first half of the 1970s and the contemporary worldwide grain shortage had a devastating impact on domestic supply of foodstuffs. The food prices in the world market increased rapidly, while this was further buttressed by the oil shock in 1973. All these adverse movements in the domestic and the world economy led to a justification of the governments initiatives to introduce price controls, rationing systems and state monopolies. The government further extended its stringent control over day-to-day life of public by imposing restrictions on transportation of rice and other foodstuffs, regulating consumption habits and forcing them to find local substitutes for imported food items. Against the severe food shortage in the local market and food price hikes in the international market, a series of drastic measures were adopted affecting the consumer subsidy system. The reductions in food subsidies were accompanied by an increase in the subsidized price of many state-owned services such as public transport, postage and telecommunication. Even with a large reduction in consumer subsidies, its remaining cost was substantial and actually recorded a significant increase by the mid 1970s. Political background It is, however, a question whether the political process was so mute allowing a smooth function of the UF government throughout the 1970-77 regime, even if the public had to face severe economic hardships, massive cut backs in subsidies and stringent controls of the government. A number of important factors that determined the political strength of the UF government are worthwhile noting here. The landslide victory of the UF at the general elections in 1970 had already given it an unprecedented political strength in securing its decision-making power. The massive defeat of the UNP, followed by the death of its leader, had weakened its political power substantially. Within less than a year after coming to office, the UF government had succeeded repressing the youth insurgency in 1971 by military means, which may have had a devastating impact for years on the emergence of such potential political threats to the government. Another source of potential threat could have been the trade unions. However, the bulk of the trade unions were under control of the LSSP and the CP, which were the partners of the UF government. For this reason, the trade unions became the defenders of the regime. The concept of workers participation in management in the public sector had been given a prominent place in the labour policy of the UF government (Chandratilleke 1997). Besides, the political attitude of the leftist trade unions against the expansion of a capitalist class was rather consistent with the governments march towards a socialist society characterized by the elements of state ownership and equity. The overwhelming decision-making power enjoyed by the UF government was used not only in bringing its economic agenda into action, but also in enhancing centralized power of the state, demanded by the majority of the civil society. In this respect, the new Constitution adopted in 1972 was a turning point. The Constitution, which was a major landmark in the process of national disintegration through the enforcement of nationalism blended with socialism, enhanced parliamentary supremacy

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and undermined judicial sovereignty (Edrisinha and Selvakkumaran 2000).16 Under the Constitution, the lifetime of the UF government was also extended by two more years by postponing the elections due in 1975 to 1977. Although the UNP and the Tamil parties opposed the new Constitution, their resistance was ineffective. In the context of a stringent regulatory framework, combined with severe shortages in domestic supply, the room for political patronage also expanded. The extended role of the state as the principle provider in the economy further strengthened room for political patronage. The political conditions favouring the smooth function of the programme put forward by the UF government, however, changed after the mid 1970s. The government was no longer able to suppress the mass opposition to economic hardship. The UNP provided the emerging mass opposition with political leadership. Even under the repressive actions of the UF government against it, the UNP grew in strength and influence in the backdrop of the countrys economic hardships and urged trade liberalization. The tensions within the government resulted in a withdrawal of the leftwing parties from the UF coalition before the general elections in 1977. The elections resulted in a massive defeat to all the parties in the UF government. It was the end of an increasingly restrictive trade regime prevalent for two decades and the beginning of the phase of trade liberalization under a new government, formed by the UNP. Policy outcome of the restrictive trade regime In assessing the policy response, it is apt to begin with a few remarks regarding the 195677 policy regime that emerged in the preceding discussion. First, the regime that was prevalent for about two decades was characterized by a gradual intensification of state control and import substitution. Secondly, it was marked by a shift from a soft phase of state control and import substitution in the 1960s to one of its hard phases in the 1970s. Finally, much of the policy efforts throughout the regime, characterized by a series of economic crises, reflected the crisis-management strategies of the government rather than those designed to address the problem at source. An analysis of the growth response to the policies adopted should necessarily take into account these important features of the import substitution regime. Apparently, the import substitution regime was marked by the initiation of an industrial sector first as a by-product of import controls and secondly as a response to forceful import substitution policies. Yet, in an overall assessment the emerging pattern of industrialization behind the protective barriers had failed to produce a sustainable growth momentum and to ease the balance of payments crisis. The manufacturing activities that emerged during the import substitution regime were more in line with the structure of import controls than in line with the comparative advantage of a labour-abundant economy. Consequently, the rate of unemployment recorded reached its historical peak levels in the mid 1970s. The small domestic market hindered the potential expansion of industry and the realization of economies of scale. Although it appeared as if export diversification was part of the policy agenda, the emerging industries never looked into export markets. On the one hand, these manufacturing activities, which did not have a competitive vigour to penetrate export
16

The Constitution of 1972 attempted to erase the existing symptoms of colonial heritage. It was under this Constitution that the colonial name-Ceylon, by which the island was known to the rest of the world, was replaced with its traditional name-Sri Lanka. 50

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markets, continued to be safe in their operation in the protected domestic market. On the other hand, even with incentives for export promotion the import substitution regime was characterized by a high degree of anti-export bias (Cuthbertson and Athukorala 1991, Pyatt and Roe 1977). Heavy import protection and the overvalued exchange rate resulted in a policy environment profitable for production for the domestic market, penalizing that for the export market. Under the incentives granted for non-traditional exports, such as BVS, CRA and FEEC systems, the sectors that recorded an improvement were not manufacturing activities but those based on the countrys natural resources such as gems and minor agricultural crops. Apparently, these commodities were not much subject to competitive pressure in the world market and did not have a sufficient domestic market in compensating for the incentives granted for their exports. In addition, the policies that favoured non-traditional exports and, the export tax system levied on the traditional exports for revenue purposes were discriminative against traditional exports. In addition there was also a pessimistic view on promoting traditional exports because the policy makers felt that an improvement in their productivity might result in a further dampening of the world prices (Corea 1971). It was most likely that the policies had resulted in a bias against traditional exports although the economy was still heavily dependent on this sector. Even though the export promotion policies were beneficial to certain exports, as they appear to have been, the economic losses associated with such selective policy intervention cannot be ignored. Given the shortage of raw materials, an important question for the industrial sector was how to increase supply for the domestic market characterized by supply shortages, leave aside the export market. The capacity utilization in industry was around 65% of total capacity in the sector during 1968-77, while in the backdrop of the oil shock it declined further to 60% (CBSL 1998). The capacity utilization in industry deteriorated largely in response to the increased import controls covering not only the consumer goods, but also the intermediate goods. This points to the fact that the policy emphasis in saving foreign exchange through import substitution was unsuccessful as it only converted import dependence of the country from consumer goods to producer goods. A forceful reduction in import dependence by no means indicated a reduction in the degree of economic dependence on the countrys traditional exports. The industrialization process (in any direction) depends on increased supply of foreign exchange to meet the growing demand for intermediate and investment goods from abroad. In the import substitution regime that resulted in freezing the export earning capacity of the country, this fundamental requirement appear to have been ignored. Import substitution strategies have been extended too long and too deep in the small economy of Sri Lanka. At the initial stages of import substitution in the 1960s characterized by moderate policy measures, there was room for expansion in meeting the domestic demand. Therefore, growth performance showed a moderately upward trend, which continued in the subsequent period of partial liberalization in the second half of the 1960s. The policy reversal in 1970 was a turning point as the economy moved from its soft phase to a hard phase of import substitution. Consequently, the growth performance slowed down, while that of manufacturing suffered seriously. By the mid 1970s, import substitution that went hand in hand over a long period of time appears to have reached its critical limits of expansion.

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Post-1977: Opening up of the Economy

The UNP government that came into power at the general elections in 1977 immediately embarked upon a trade liberalization programme in which export-oriented industrialization received priority. The policy reforms were justified strongly by economic and political forces that were in operation internally and externally. Given the dismal economic performance of the pre-1977 restrictive trade regime and the consequent economic hardship of the masses, there was a need for a radical change in policy direction. This was confirmed by the election results. The electorate conferred a massive victory to the UNP that campaigned for trade liberalization. The growth experience of more liberalized and export-oriented economies, such as those of the NICs, provided a clear example of the success story of trade liberalization. On the basis of the outcome of the theoretical and comparative studies at the time, the change in world development perspectives in favour of trade liberalization rationalized the policy shift. The policy reforms also satisfied the requirements of international capital flows and the conditionalities of development assistance. Policy reforms The policy reforms were aimed at integrating the domestic economy with the international markets and creating an environment conducive for market forces to function. At the same time, the role of the government that had expanded as a major entrepreneur in economic activity and as a main provider to the people was abandoned. Thereby the policy reforms were aimed at facilitating the expansion of the role of the private sector including FDI. By changing its own historical policy stance favouring import substitution in agriculture, the new UNP government placed greater emphasis on export-oriented industrialization. Trade policy reforms were based on the argument that protection received by domestic industries from tariffs and quantitative restrictions was excessive and widely dispersed across sectors. Excessive protection had penalized exports and encouraged misallocation of resources hindering potential export expansion. Under the Tariff Reform Commission,17 which was set up with the assigned task of revising the tariff structure, the intention was to achieve a tariff regime with a reasonably low and fairly uniform tariff structure. A six-band tariff structure was implemented in 1977 by reducing most of the tariffs on essential goods, intermediate goods and investment goods, while the tariffs were kept under continuous review. The most important change in import controls was not the tariff revisions, but the elimination of the quantitative restrictions on most of the imports by replacing them with tariffs under the OGL system. The policy reforms included a drastic change in exchange rate policy by shifting from a dual, fixed exchange rate system to a unified, managed floating exchange rate system with a drastic devaluation of currency by 45.5% against the US Dollar.18 The new system provided greater scope for the market forces to influence the determination of the exchange rate in which the Central Bank intervened in smoothing out its erratic fluctuations. The period after 1977 was also marked by a significant relaxation of
17

The Tariff Reform Commission came to be known as the Presidential Tariff Commission (PTC) after 1980. 18 Estimated from year-end exchange rates, there has been a 46% devaluation of the Sri Lankan Rupee in real terms against the US Dollar (Table 13). Sri Lanka 52

exchange controls over current account transactions. Although the Sri Lankan Rupee was not made to be fully convertible, the relaxation of restrictions on capital transactions was of importance in the respect of integrating the domestic capital market with the international market. Reforms in the areas of trade and exchange rate policies reflected the governments attempt to eliminate anti-export bias in policy and to provide an incentive system for export promotion. The reduction in excessive import protection was expected to facilitate greater utilization of industrial capacity, to gain from cost advantage, and to encourage efficient use of resources. The flexible exchange rate system was expected to improve export competitiveness and to ensure increased profitability of exporters under a realistic exchange rate. Apart from liberalization policies aimed at establishing an export-oriented trade regime, there were also special incentives granted to the exporters of manufactures. Many of these incentives granted to exporters appeared to be selective among different export industries and to be discriminative between export and import substitution industries. These special incentives included the exemption of imports of intermediate and capital goods from import duties, fiscal incentives through direct cash subsidies and tax concessions, credit facilities, and others such as infrastructure and institutional facilities.19 The selective nature of intervention in export promotion, however, declined after the late 1980s, as the government was inclined to provide more neutral incentives for exports since then. The initiatives were taken by the government to change its role in a number of ways. Allowing the private sector to replace it, the government substantially reduced the entrepreneurial role that it had previously undertaken. In line with this, domestic private and foreign investments were expected to play major roles in economic growth. In the Budget Speech of 1978, it was stressed that the public sector will concentrate on essential areas that are not attractive to the private entrepreneur either because the investment involved is too large or because the financial rate of return is not attractive. On the basis of this argument, the government investment was confined to large-scale development projects, particularly in the area of infrastructure. In addition, the government took steps to rationalize state-owned enterprises in the form of partial divestiture, liquidation, management contracts and franchising in order to make them efficient and commercially viable (Kelegama 1997). Although there was much concern about privatizing inefficient state-owned enterprises, a proper privatization programme did not come into being until the beginning of the 1990s. While restricting the entrepreneurial role of the government, its involvement in regulating the market forces and providing the social services of the people also came under revision. State monopoly that had extended over import trade and distribution of the basic commodities was withdrawn and, most of the price controls were removed. A
Various forms of export promotion schemes including direct cash subsidies were implemented under the auspices of the Export Development Board (EDB) established in 1979. The EDB was a reformulation of the former Export Development Secretariat as a semi-government body with independent legal and financial status. Another important aspect of institutional support was the establishment of the Greater Colombo Economic Commission (GCEC) in 1978 to operate newly established export processing zones to attract foreign investment into export-oriented industries. In 1990, the GCEC was merged with the Foreign Investment Advisory Committee (FIAC) that was concerned with foreign investment outside the GCEC areas to form one-stop centre for investors, with increased responsibilities its status was elevated to a Board of Investment (BOI) in 1992. Sri Lanka 53
19

radical change in social welfare policy was the abolition of the direct consumer subsidies including the rice ration system. The rice ration system that covered the entire population was replaced in 1978 by a system of food stamps to a targeted low-income group, which resulted in a sharp reduction in expenditure on consumer subsidies. Even though health care and education continued to be free, private investment in these areas was also encouraged later. Political reforms The intention of the leadership of the UNP was to move away from control to liberalism in the economic sphere and, from liberalism to control in the political sphere (Abeyratne 2000, Fernando 2000, Moore 1990). Therefore, policy reforms in 1977 were accompanied by political reforms, in reaction to the prevalent traditional political economy that constituted important rules of the game in the post-independence development process. Moreover, there was an attempt to understand ill effects of traditional political economy on development performance of Sri Lanka by looking at the political and economic structures of the NICs. Thus the political reforms after 1977 resulted in the countrys controversial move towards a near-authoritarian political regime. The leadership of the UNP government believed that sustainable growth could be achieved only in the context of a supportive political structure that would ensure a longterm political stability of the government and a simplified and firm decision-making power of its leadership. This required an end to the historical policy and political swings in the country, a neutralization of political resistance exercised by direct political parties as well as semi-political pressure groups in society. One of the major steps in achieving long-term political stability and authority was to change the Constitution in 1978. The requirements for political stability and strong leadership, freed from the whims and fancies of parliament were embodied in the new Constitution, which created an Executive Presidency undermining the notion of parliamentary and judiciary sovereignty (Edrisinha and Selvakkumaran 2000). Through the centralization of powers in the hands of the Executive President, the constitution provided simplified decision-making power. The new leader of the UNP, J.R. Jayewardene, became the first Executive President in 1978 for a six-year term and, was elected again at a presidential election in 1982 for a second term. In addition to the constitutional reforms that enabled the government to move towards a virtually authoritarian political regime, a series of attempts were made to repress the rival political parties including the SLFP and semi-political pressure groups including the trade unions. The repressive measures adopted by the UNP government to control over political dissent and resistance were seen as encompassing even the use of state violence. Policy responses An analysis of policy effect on the countrys growth performance in the liberalized trade regime created mixed perceptions. Apparently, compared with the dismal economic outcome in the pre-1977 restrictive trade regime, the gross achievements in growth performance and export expansion were remarkable. However, they fell far short of the initial ambitions of the government that looked at the East Asian success stories as a model.

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The early stage of trade liberalization that could possibly be extended till the mid 1980s created much hopes that Sri Lanka would soon be one of the second generation NICs in Asia. The rate of economic growth with an initial upsurge in 1978 remained on average above 5% level. At this stage much of the contribution to economic growth came from the expansion of the construction and service sectors, which grew on average at about 7% rate. The governments strong enthusiasm to complete large-scale infrastructure projects within a short period of time, in utilizing the increased flow of foreign funds in the backdrop of liberalization, resulted in a massive expansion in the construction industry. The expansion in construction and service sectors partly reflected the nature of a Dutch decease effect that resulted from an increased domestic spending on non-tradable sectors with a corresponding contraction in the share of tradable sectors. Industrial restructuring in response to drastic changes in the trade regime required time. Besides, there were economic costs of adjustment as trade liberalization had negative repercussions on domestic industries that had developed and survived behind the protective barriers (Athukorala 1986, Kelegama 1991, Osmani 1987). However, the net outcome of the industrialization process was positive, as particularly after the mid 1980s the industrial sector, which showed a steady increase in its share, became the major factor determining the trend of GDP growth. The role of the FDI in export-oriented industrialization expanded significantly. As the incentive package offered to foreign investors was found to be highly attractive, this combined with the countrys political stability at the time, created a new investment centre of Asia (Athukorala 1997). Export-oriented industrialization recorded outstanding achievements. Agricultural exports that dominated the countrys export structure for decades by recording about four-fifths of total exports even in 1977 declined to half of the total exports within ten years as a result of rapid expansion in manufacturing exports. By the mid 1990s, industrial exports accounted for over three-fourth of total exports as the share of agricultural exports declined further to around 20% of the total. The expansion of exports in labour-intensive manufactures reflected that the country was specializing along the lines of its contemporary comparative advantage. The initial upsurge in economic performance in the liberalized trade regime soon came to a critical point from both policy and political fronts. The countrys economic and political problems affecting growth performance had taken a new direction in the liberalized trade regime compared to those in the restrictive trade regime. Political turmoil combined with macroeconomic instability was the major factor that brought about a slump in growth performance during the second half of the 1980s. Macroeconomic instability On the part of the macroeconomy, despite higher growth performance and export expansion, a number of factors that were in operation produced worsened fiscal and external imbalances. Driven by both political and economic objectives, with foreign financial assistance the government undertook massive public investment projects. Such as the Mahaweli River Diversion Project, the Housing Programme and the Urban Development project. The massive increase in foreign funds flowing into infrastructure projects forced the government to supplement their investment with domestic borrowings. As a result of the upsurge in public investment, the capital expenditure increased to around 15% of GDP with an exceptional rise in 1980 to about one-fourth of GDP. As the government revenue nearly covered only current expenditure, almost the

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total increase in capital expenditure added up to the budget deficit. The consequent monetary expansion resulted in a move towards a new era of an inflationary regime with a double-digit rate of inflation, which recorded 26% as its highest figure in 1980. This was further contributed by the governments withdrawal of consumer subsidies and price controls. The sharp rise in inflation mounted pressure on the real interest rate and real exchange rate. By the mid 1980s, it appeared that much of the incentive effects of initial devaluation had faded away due to an overvaluation of the currency in real terms. Along with aggravating fiscal operations, the external finance position too deteriorated. By the time that the UNP government came into power in 1977, the external finance position was favourable, as a result of the tea price boom in 1976-77. The terms of trade improved by 72% during 1976-1977, while external reserves in terms of months of imports increased from 1.7 in 1975 to 5.9 in 1977. The trade balance, for the first time after 1956, also recorded a surplus of US$ 40.9 million in 1977, along with US$ 144.1 million surplus in the current account. The upward movement in terms of trade on the eve of policy reforms resulted in an unprecedented upsurge in imports facilitated by trade liberalization. The favourable movement of the balance of payments position on the eve of the UNP regime was, however, short-lived with the second shock coming in 1979. The export earnings fell far short of the increased import expenditure resulting from the increased volume of imports (due to the relaxation of import controls) as well as the sharp rise in import prices (due to the oil shock). The trade balance, after its healthy surplus in 1977, recorded a massive increase in deficit from US$ 180.3 millions in 1978 to 986.6 in 1980. If the capital inflows and transfer receipts, which were on the upward path in the liberalized trade regime were not there, Sri Lanka could have plunged into a deep balance of payments crisis. There were policy and political impediments to trade liberalization. Although the government had committed itself to confine its role to large-scale infrastructure build up, its initial policy towards existing state-owned enterprises was muted. The government kept postponing its privatization programme for more than a decade even though most of the inefficient state-owned enterprises were draining an increasing amount of transfer payments to cover the losses. Besides, as in the previous regime, they provided an important source of disbursing political patronage by providing employment to the supporters of the politicians (Kelegama 1997). The state-owned plantation sector, which had recorded a poor performance since its nationalization under the previous regime, continued to exist under the inefficient public management system. With aggravating internal and external balances in the 1980s, the government was inclined to delay and even to reverse its liberalization programme. Given the discrepancies in protection between import substitution and export-oriented industries, the manufacturing sector suffered from anti-export bias in policy in the 1980s (Abeyratne 1993, Ratnayake 1988). The anti-export bias indicated that the favourable treatment accorded to exports was small when compared to the policy bias towards the domestic market resulting from high tariff protection. Apparently, in an economy that used to be in a highly restrictive trade regime the cost of adjustment to liberalization would be immense. The removal of price controls and import restrictions had already resulted in an increased cost of living and a collapse of domestic industries in creating social discontent. Privatization of state-owned enterprises meant a further increase in unemployment and price levels in the process of adjustment. The regime had inherited

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the problem of high unemployment of particularly the educated youth from the previous restrictive regime. In addition, as we have discussed below, the government had to deal with the frustration and resentment of both Sinhala and Tamil youth, demonstrated in the form of civil wars. Therefore, a radical programme of action for an abrupt pace of liberalization did not appear to be a politically feasible option. Political instability: the twin civil war An escalation of political instability after 1983 gave no time for the economy to recover from the macroeconomic instability at the early stage of trade liberalization. The government had to confront a civil war that emerged in two facets. One was the war in the South led by the JVP that erupted for the second time with the objective of capturing state power. The abortive insurgency of the JVP in 1971 had already indicated the symptoms of growing militancy among the Sinhala youth. On a much larger scale, the JVP launched its second armed struggle in 1987-1989. The Tamil youth groups led the other in the North with the objective carving out a separate Tamil state in Sri Lanka. The growing militancy among the Tamil youth since the mid 1970s had converted itself into a separatist war after 1983. Even though, the war in the South came to an end in 1989, despite temporary truce occurring intermittently, the war in the North continued. It is true that the civil war in two facets emerged in the backdrop of the governments attempt to move towards a liberalized trade regime. On the basis of the sequence of events, some analysts have seen that civil wars as a price that the country had to pay for its inadequate attention to distributional issues in the course of economic liberalization (Dunham and Jayasuriya 2000). This is, however, an oversimplification of the political issue, which was a product of the countrys historical development process extending well beyond the post-1977 political regime. The political grouping of militant youth from both the Sinhala and the Tamil communities against the established democratic political order of the country reflected the growing political conflict between and within the communities. Among other things, the inherent development contradictions in an intensified restrictive trade regime were in the heart of the emergence of this twin political conflict (Abeyratne 1998). The growing proportion of youth, nurtured within a state of welfare democracy, emerged in the 1960s and the 1970s with high social aspirations and improved human capabilities. The state, operating within a restrictive trade regime, failed to generate resources and opportunities to meet the social aspirations and to utilize the human capabilities of this growing youth category, which was excluded from the mainstream development process. Therefore, the restrictive trade regime had provided fertile ground for the emergence of political conflict, which only erupted as a civil war in two facets in the post-1977 political regime. During the three-year period of 1987-89 when the entire country was under civil war conditions, the growth of GDP declined to 2.1% on average per annum. The war was a major contributory factor to aggravating fiscal operations and balance of payments as it resulted in an alarmingly increased military expenditure. The defence expenditure, which accounted for only 1.6% of total government expenditure in 1980, increased to 6.7% in 1990 and, to 16.9% in 2000 (Table 10). An increase in expenditure on imports of military goods and the decline in income from tourist earnings contributed to an increase in current account deficit in the balance of payments. This was accompanied by a slow down in FDI flows that showed an increasing trend until 1982. These developments on the part of external finance against the civil war continued to result in a deficit in the

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balance of payments in the second half of the 1980s. The second half of the 1980s, which was the most turbulent period of war, in a sense that political and economic repercussions of war were widespread throughout the entire country, was marked by the poorest growth performance in the liberalized trade regime. However, the decline in growth performance during 1987-89 is negligible as far as the overall long-term adverse effects of the war are considered, because the war had prevented the achievement of macroeconomic stability and retarded the potential economic growth. Second Wave of Liberalization and Signs of Recovery The new UNP government elected in 1989 and its new leadership, R. Premadasa, who became the second Executive President of Sri Lanka, had two major tasks that required urgent attention. The first was to deal with the twin civil war and the second, to get the economy out of its recession. With the military success in the South and the temporary truce in the North, the government succeeded in bringing the country back to some normalcy. This was accompanied by policy reforms in 1989 in setting the stage for a second wave of the liberalization process. The policy reforms were aimed at stabilizing the economy with fiscal and monetary prudence, reducing pressure on the balance of payments, deregulating the market mechanism and enhancing export promotion. The four-band tariff schedule, proposed in 1989 for implementation within the next four years, resulted in a substantially low and simplified tariff structure with a significantly low dispersion of the rates across the sectors. The currency was devalued by 17.4% against the US Dollar in 1989.20 By 1994, the Sri Lankan rupee was fully convertible on current account transactions. In enhancing export promotion, the government declared the 1990s as the decade of exports. This shows a revival of the export promotion drive, which had been undermined by popular public investment programmes at the initial stage of trade liberalization. Taxes applied on traditional exports were reduced and, the tax concessions granted to the investments in EPZs were extended to the exporters outside the EPZ areas. An important institutional reform was aimed at simplifying the foreign investment approval procedures.21 The privatization programme, which was delayed since the inception of the liberalized trade regime, also came into effect under the title peopelization, which seems to be politically more attractive than the term privatization.22 The painful experience with the twin political conflicts of rural youth and the strong appeal for distributive equality influenced the redistributive policies that emerged in the 1990s. They were further influenced by the mutual antagonism between the old elite groups that dominated the traditional UNP and its new leader, R. Premadasa, coming

20

The Sri Lankan Rupee depreciated by 12.2% against the US Dollar in real terms in 1989, estimated on the basis of the year-end exchange rates (Table 14). 21 There have been two institutes concerning foreign investment as the Foreign Investment Advisory Committee (FIAC), which operated with the assigned task of approving foreign investment outside the EPZs and the Greater Colombo Economic Commission (GCEC), for approving foreign investment within the EPZs. The FIAC was merged with the GCEC to provide services to foreign investors in one-stop centre in 1990 and raised its responsibilities by elevating it to a Board of Investment (BOI) in 1992. 22 However, under the peopelization programme, it was expected to establish a broad-based public ownership in which the corporate sector held a larger percentage of shares and management control, while employees also received 10% of shares as a gift. Sri Lanka 58

from a modest social background, who wished to get his political power established in the lower social strata (Dunham and Kelegama 1997). Even though the Tamil separatist war restarted in 1990 after the collapse of the negotiations between the Tamil rebels and the government, the period of 1990-94 was marked by an improvement in growth performance. The economy grew at an average 5.5% per annum, with improved private investment to 24.0% of GDP in 1994 from 16.0% in 1989. FDI and short-term foreign capital flows recorded a massive increase when compared to those in the past. Together with an increase in foreign capital flows, an improvement in terms of trade contributed to a healthy balance of payments surplus in the early 1990s. There were significant changes in the governments fiscal operations too. Since the late 1980s the governments revenue, which was affected by the reduction in tax income, continued to remain below current expenditure recording a deficit in the current account. Nevertheless, the budget deficit too declined mainly due to the reduction in capital expenditure after its initial upsurge in the early period of liberalization. In an overall assessment, it appears that even in the midst of civil wars in the North the economy was setting groundwork for rapid growth. The Presidents vision was to achieve the NIC status by 2000. Contrary to this anticipation, however, the growth momentum in the early 1990s was short-lived, while the UNP regime came to an end in 1994. Shift in power and economic slow down At the presidential and parliamentary elections held in 1994, a SLFP-led coalition named the Peoples Alliance (PA) returned to power by ending the seventeen-year rule of the UNP. The major issues that resulted in a defeat of the UNP at the elections were more political than economic, as they pointed towards state authoritarianism, fear of terror, corruption and state-sponsored violence that escalated during their tenure. In reaction, the PA at its election campaign, pledged to redress the open economy with a human face. In terms of development strategy of the country, the political change from UNP to a SLFP-led coalition in 1994 was important since it marked an end to the policy swings accompanied by political swings between the two dominant parities. There were a number of factors that may have led the SLFP to rethink about its ideological position and to change it in line with that of the UNP. It was certain that the electorate would no longer vote for returning to a controlled trade regime. The influence of the internal as well as international forces on the old policy stance of the SLFP had faded way. The SLFP had already witnessed greater economic performance brought about by the liberalized trade regime when compared to its own restrictive trade regimes in the past. The greater economic performance in a liberalized trade regime was already a confirmed phenomenon, since there were ample evidence on the success stories under liberalized trade regimes in developing countries, particularly in East and Southeast Asia. After all, the Constitution of 1978, which almost ensured no more changes in that, forced the political parties representing future governments to stick into the existing political and economic structure protected by the Constitution. The PA government came to office in a favorable economic environment with an unprecedented trust placed by the electorate on its leadership after defeating the

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seventeen-year near-authoritarian rule of the UNP.23 As we have already seen, economic growth was rising in the early years of the 1990s with enhanced export performance. Even globally, major industrial countries started to experience an economic boom since the mid 1990s facilitating greater export expansion in developing countries. Apart from enhancing the prevailing liberalized trade regime, much of the governments effort was concentrated on fiscal consolidation. This was accompanied by a further reduction in tariffs and controls over foreign exchange transactions. Accelerated privatization programme and the restrictions on public expenditure were expected to reduce the pressure on the budget deficit. The budget deficit was maintained just below 10% of GDP in the second half of the 1990s. Even though this was a significant achievement when compared to the high budget deficits in the 1980s, still it was far from the budgetary targets of the government. The economy grew at 5.1% on average during 1995-2000 when compared to the governments ambitious target of 8% outlined in its first Budget Speech in 1994. Apart from the fact that the government failed in achieving its macroeconomic targets, the economy gradually started showing the symptoms of a potential economic slow down. The fundamental weaknesses of the fiscal operations, reflected by a widened gap between current expenditure and total revenue, necessarily forced the government to restrict capital expenditure in order to achieve fiscal prudence. This was further contributed to by an alarming increase in defence expenditure from 6.7% in 1990 to around 17% in the second half of the 1990s, as a percentage of total expenditure (Table 10). In addition, the interest payments on public debt, which was less than 10% of total expenditure in the early 1980s, had become the largest single expenditure component in fiscal operations accounting for over 20% for most of the years in the 1990s. Thus, expenditure on defence, interest payments and welfare (including education and health) together accounted for about two-thirds of total government expenditure by 2000. Therefore, the achievement of fiscal prudence was difficult and the government attempt for same, necessarily resulted in a massive reduction in capital expenditure. Despite a continuity in terms of trade improvement, the exports as a percentage of GDP became stagnant after the mid 1990s. Particularly, the growth of manufacturing exports (measured in US Dollar terms) recorded a declining trend after 1993 with negative rates of growth towards the end of the decade (Abeyratne 2000). Even though its pressure on the external finance position was intermittently cushioned by other forms of foreign exchange receipts, including privatization proceeds, in general the capital account balance deteriorated significantly when compared to its favourable position in the first half of the 1990s. In fact, the greater emphasis on privatization after 1994 reflected more of the governments intention to reduce fiscal and balance of payments deficits than improving the efficiency and profitability of these enterprises. The balance of payments position also deteriorated towards the end of the decade and recorded its highest deficits ever in the entire period of liberalization after 1977. Even though there was no change in the basic policy framework after 1994, the question what went wrong during the PA regime is appealing. Despite political rhetoric on enhancing growth performance, the government, unlike in the previous cases, failed to
23

At the presidential elections in 1994, the Presidential candidate and the leader of the PA, Chandrika Bandaranaike Kumaranatunge obtained 62% of votes, which is the highest majority of votes ever obtained by a Presidential candidate. 60

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introduce a radical policy package for enhancing export promotion and growth momentum. On the economic front, much of its effort appears to have been reduced into achieving fiscal consolidation, which was intended to enhance growth momentum. The policy emphasis on industrialization and export promotion appears to have become secondary objectives, when compared to the early 1990s. Even the bad weather conditions and the resulting power crisis affected both agricultural and industrial production. In spite of that, the PA came to office by re-awakening the popular old political traditions, which were previously kept under control by, not the institutional reforms, but strong political leadership. The tradition of consumer subsidies, pro-labour and anti-entrepreneurial sentiments, as well as anti-growth institutions embedded in popular democracy re-emerged after the collapse of the previous regime and were favoured by the PA government driven by political objectives. Given the resurgence of political liberalism after the defeat of the UNP government, the PA government exposed itself to the political resistance affecting its authority and decision-making power. Even though the Executive Presidential system had already established a simplified decisionmaking process in the context of a week parliament, the abolition of this system with constitutional reforms was also a pledge made by the PA leadership. Contrary to the initial trust on the new changes, soon the government was inter-locked within its own agenda and the business confidence deteriorated. Much of the governments attention was drawn by political issues (such as Constitutional reforms, the separatist war and the survival of the government itself) undermining the importance of economic issues. The government suffered from the lack of political consensus within the PA itself, as it was a coalition comprising different political parties and personalities varying from conservatives to communists. Having a majority of just one seat in the parliament, the endurance of the government was of prime importance above all other concerns. In fact, the leadership of the PA succeeded in continuing the PA regime throughout its entire term until the general elections due in 2000.24 With regard to the Tamil separatist war, after the failure of peace negotiations the government had to enter into a stage of an intensified war with the Tamil rebels. This weakened the regime both economically and politically. Despite much concern over a major Constitutional reform, which was proposed primarily as a political solution to the ethnic problem, the government never succeeded it, due to the lack of two-thirds majority in the parliament. Thus, although political issues received high priority in the PA agenda, the government did not show much of a success in this case too. Despite the initial promise of redressing the open economy with a human face, the PA regime was also a continuation of a less-transparent and less-accountable system of governance. Therefore, the PA regime exhibited elements of both week and bad governance contrary to the strong and bad governance during the UNP regime.

IV. Major Puzzles in Growth Experience

The PA won for a second term at the presidential and general elections held in 2000. Although the leader of the PA, Chandrika Bandaranaike Kumaranatunge continued to be in office as the Executive President, the PA government collapsed next year as the Muslim Congress withdrew from the coalition. The incidence was interpreted as a constitutional crisis. A UNP-led coalition named United National Front (UNF) formed a new government in 2001. Sri Lanka 61
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Whatever the measures used, and assessments undertaken, it is difficult to challenge the notion that the growth performance of Sri Lanka over the past five decades has fallen far short of its potentials. Why did Sri Lanka fail to make use of the countrys initial advantageous position to establish the conditions for rapid growth? What made Sri Lanka resort to an increasingly restrictive trade regime, notwithstanding the dismal growth performance under trade restrictions? Even with relatively higher growth performance in the liberalized trade regime, why did the country delay in setting the conditions for sustainable growth and stability? Finally, to what extent can the political structure be related to policy reforms and growth performance?

Initial Advantage: a Blessing or a Curse?

Ideally, the initial advantageous position should have had constituted the very necessary foundation for achieving a sustainable growth momentum in Sri Lanka. The initial economic prosperity based on the primary exports was identified in terms of high per capita income, sound fiscal operations and strong balance of payments of the country. It reflected the capacity of the state for potential accumulation of agricultural surplus needed for the financing of industrialization in the country. When compared to many other newly independent countries in the Asian region, the accumulated foreign exchange reserves were uniquely advantageous for Sri Lanka to embark upon industrialization, a fact identified even by policy makers (Ministry of Finance 1951, Oliver 1957). On the contrary, however, the country subsequently entered into a stage of deep and prolonged economic stagnancy in which much of the initial advantage faded away. The first puzzle that emerged from the Sri Lankan growth experience is therefore, a unique one, when compared to those of many other countries in the South Asian region. Why did Sri Lanka, which was blessed by such an initial advantageous position, fail in exploiting it to achieve a sustainable growth momentum? Initial prosperity taken as a permanent state The policy makers, influenced by the historical experience under colonial governments, were comfortable with the existing economic conditions at the time, and overlooked the possibilities of converting the initial economic prosperity to achieve a sustainable growth momentum. Given the initial economic prosperity, this need did not actually arise at the time with a strong appeal for structural changes in production and exports. Ample evidence documented at the time, suggests that Sri Lanka was already among the highest in the developing region and promised to be the best bet in Asia. In this context, as perceived by the policy makers, the achievement of agricultural self-sufficiency and the expansion of social welfare would have solved the remaining developmental issues. In respect of an import substitution policy in agriculture, the view of the Sri Lankan policy makers was similar to that of their external advisors. It was their perception that Sri Lanka had not yet fulfilled the preconditions for industrialization, which was further rationalized by the dismal performance in most of the existing war-generated manufacturing ventures. The policy makers were not readily convinced by the contemporary terms of trade issue in primary-exporting countries and its economic implications, because a series of favourable external shocks prevented them from recognizing this issue.

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The consumption and expenditure patterns developed out of the initial economic prosperity seem to have been irreversible, but unsustainable in the absence of a rapid economic growth. The initial rise in income was accompanied by an even faster rise in both government and private consumption. In the absence of an industrial capitalist class, naturally there was not much accumulation in the form of industrial capital. Therefore, both the policy makers who treated the temporary favourable initial conditions as if they were a permanent state of the economy, and the private sector, which did not receive policy guidance, failed in promoting adequate investment in order to achieve rapid economic growth. This was not entirely a policy issue of economic growth, because it was strongly associated with the political commitment to social welfare and the pluralistic political system of the country. Social welfare as a source of policy dilemma In the first Budget Speech of independent Sri Lanka in 1948, the Minister of Finance, J.R. Jayewardene (who became the first Executive President in 1978), remarked: Free Sri Lanka may justly and proudly call itself a social service state (Marga Institute 1974: 6). This early remark on the countrys extensive welfare system reveals the inescapable political commitment to build a social welfare state in Sri Lanka. The Sri Lankan experience, thus, reflects a strong attempt to achieve consumption and welfare standards developed in the Western industrialized countries even in the absence of an economic foundation for their sustainability (Robinson 1959). Social welfare is, however, justified in conventional development thinking on both equity and efficiency grounds. With regard to the justification based on equity criteria, the poor should have the right of access to basic needs by reducing the gap between the rich and the poor. Thus, social welfare, by improving an egalitarian distribution pattern, fulfils certain developmental achievements. Contrary to the argument for an egalitarian distribution pattern, the Sri Lankan welfare system continued to subsidize the basic needs of not just the poor but of the entire population. On the basis of the efficiency criteria, social welfare is justified as it improves abilities and attitudes to work. Thus, improvement in human capabilities is important as a prerequisite in achieving rapid economic growth. The Sri Lankan experience suggests that mere improvement in human capabilities would not enhance economic growth, as it should be accompanied by an expansion of opportunities. Whatever the validity of these justifications in the Sri Lankan context, the advantage of the initial high per capita income was instrumental in expanding the state of social welfare, and in achieving high welfare standards of the population. As we have already seen in the preceding analysis on policy responses, the major problem at source was not the maintenance of an extensive welfare system, but the broad economic policies that undermined even the sustainability of this welfare system. However, it is not at all possible to leave the welfare system out of the overall problem of economic growth. Even though it is not possible to construct a direct tradeoff between welfare and growth, an extensive welfare system became the source of a wide range of political-economic issues in the subsequent period. With a rapidly growing population at the time as a result of what Robinson (1959) called a primitive birth rate combined with a modern death rate (with the support of the welfare system itself) and aggravating fiscal operations in a stagnant economy, the

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maintenance of social welfare became an onerous exercise in contributing to growing budget deficits. Without targeting a low-income group of the population, the Sri Lankan welfare system covered the entire population, which doubled from 7 million to 14 million during the period of 30 years after 1948. In this context, the rapid increase in overall welfare expenditure in absolute or relative terms did not necessarily mean an increase in the welfare of an average citizen. In addition, an inescapable welfare system in the country set the parameters of popular political participation in the decision-making process, and of political competition among political parties for power, constituting a policy dilemma for policy makers. The political swings at frequent general elections and the maintenance of social welfare were related to one another to a great extent. Therefore, the strong social and political commitments to social welfare were responsible for undermining policy emphasis on economic growth. The contradiction in the system emerged due to the fact that sustainable economic growth constituted the very necessary foundation of maintaining social welfare in the long run. The validity of any redistributive justice is likely, in the long run, to be seriously undermined by economic stagnation (Lakshman 1975). This was not only because the maintenance of an extensive welfare system required resources to finance it, but also because the state needed to generate additional resources and opportunities to meet social expectations and human capabilities expanded through social welfare (Abeyratne 1998). The failure to achieve rapid economic growth undermined both requirements in the subsequent decades. In the absence of rapid economic growth, the strong commitment to social welfare in the Sri Lankan policy stance forced people to share poverty rather than wealth. The typical comparisons of the social development indicators of Sri Lanka with those of the other countries simply ignored the fundamentals of the viability of a direct approach to development presenting a misleading picture. Democracy and political will The decision-making process in democratic political structures is more complex than in authoritarian political systems. There are important implications of both systems on economic growth. Even though an authoritarian political system does not necessarily guarantee a rapid economic growth, at a high political risk it has more control over political institutions affecting growth. In contrast, the decision-making process in a democracy is subject to the popular preferences constituted by different interest groups, semi-political organizations and political parties. However, it is often argued that the systems, which ensure reasonable political rights to the people, create environments conducive for economic growth. In a regression analysis, Khasnobis and Bari (2000) found that indicators of civil and political rights are not significant in explaining growth performance in South Asian economies. However, in an analysis based on the Indian and Sri Lankan experience, Kelegama and Parikh (2000) confirmed that the elements of political structures in both countries were important in explaining their economic policies and growth performance. The democracies provide greater room for the popular will of the majority in deciding what is best. However, because these political systems in which the influence of different interest groups, semi-political organizations and political parties condition the political will of the leadership, arriving at a political consensus over the question what is best is not as simple as it appears to be. The political will is determined more by the

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objective reality than by the personal attributes of the political leaders (Kelegama and Parikh. 2000). Either in democratic or authoritarian political systems, the political will of the leadership is far more important for economic growth. Therefore, the lack of political will in a given context is significant in overlooking the possibilities for achieving sustainable growth momentum. The historical developments in state policy and political institutions combined with the basic elements of the contemporary economic conditions were instrumental in determining the political will of Sri Lanka. Prior to independence, the political leaders shared power with the British rulers in the Colonial State Council and became the political leaders of the first national government through a peaceful transfer of power. It was within this political environment that the ideological position of the conservative political leadership was formulated, in such a manner that there was be no conscious attempt for a drastic change in state policy. The contemporary economic prosperity inherited from the colonial past provided a strong justification for the state philosophy. In addition, there was also a need to contain the strength and influence of political rivals (the left-wing parties), and the resistance created by working class and peasant unrest. Expansion of social welfare, concentration on agricultural development, disengagement in industry and the alienation of leftists in the plantation sector (through the disenfranchisement of the Indian Tamil population) were all instruments of containing the strength and influence of the political rivals and resistance against the conservative regime. On the part of the popular participation in the decision-making process of the government, the influencing of the public with a high degree of political consciousness was imperative. The early development of political institutions on the basis of universal suffrage, labour legislation of a social democratic nature, the working class movement, the leftist movement and free education, had a greater influence on the political economy of the decision-making process (Chandratilleke 1997; Kearney 1973, Jayawardena 1985). The multi-party system of governance subject to the five-year (later six-year) electoral schedule provided them with the required political force for public influence on decisionmaking. Policy makers interlocked The smooth function of the political economy created at the time of independence was dependent on the fortunes of the plantation economy. Among all the South Asian economies, Sri Lanka was an open economy in terms of the share of exports plus imports of around 70% of GDP reflecting the countrys high dependence on primary exports. The commodity booms in the early 1950s further strengthened the system in which government and private consumption as well as social welfare was reported to have escalated. However, the world market conditions favouring the countrys primary exports came to an end, recording a steady decline in the terms of trade in the long run. Moreover, the initial commodity booms never returned in such magnitudes as in the early 1950s. If the initial economic prosperity had been taken as the permanent economic position of the country, this popular belief was soon proved to be wrong. Against the downturn of the economic prosperity, the smooth function of the political economy that had developed since the latter part of the colonial period was challenged. The policy makers themselves appear to have been interlocked within the

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system that they maintained on the fortunes of primary exports. The public consumption was hard to cut down, as it would have exposed the government itself to political resistance. In this respect, the abortive attempt at reducing welfare expenditure in 1953 provided a historical early lesson to the policy makers, since it resulted in a massive violent protest challenging the power and authority of the government. One important aspect that had been ignored in the early policy dialogue on both growth and welfare was the contemporary population pressure (Alailima 2000). Rapidly growing population at the rate of 2-3% per annum, at the time inevitably resulted in an unprecedented expansion of public and private consumption including welfare expenditure, but required employment opportunities to be created outside agriculture. However, as Robinson (1959: 41) noted, Ceylon [Sri Lanka] has tasted the fruit before she has planted the tree. In the Sri Lankan economy where the industrial capitalist class has not yet emerged but trade unions to share the profits, the welfare-oriented policy of the authorities failed to evolve an adequate substitute for private enterprise. The policy makers were reluctant to address the macroeconomic issues at source and were unable to adopt a long-term perspective in policy making. Thus, the government was locked into a largely unproductive expenditure pattern that was unsustainable in the long run, without rapid economic growth. In an economy organized as such, the favourable initial conditions acted as a curse rather than a blessing in terms of achieving a sustainable growth momentum.

Trade Restrictions and Economic Growth

In an overall assessment of the long-term growth performance of Sri Lanka, a typical question in issue has been why the country entered into a stage of deep and prolonged economic stagnancy. This issue has much more to do with the choice of trade regimes than with the internal and external shocks. Generally, the strong relationship between growth performance and trade strategy is now a fairly established one, and is confirmed by the empirical studies and theoretical developments since the 1970s. Perhaps, the Sri Lankan experience provides one of the best examples of the responsiveness of an average growth performance to the variations in the degree of market distortions in a particular trade regime. Generally the comparisons between the poor growth performance in the pre-1977 restrictive trade regime and the higher growth performance in the post-1977 liberalized regime are well documented in the Sri Lankan development literature. In addition, one should note the variations in growth performance not only between but also within the restrictive and liberalized trade regimes. In this respect, one might be puzzled by the fact that there has been a substantial divergence of growth performance between the initial phase of the import substitution regime in the 1960s and its final phase in the 1970s. An equally important puzzle is why import substitution and state intervention continued for about two decades and gradually tightened, even when the growth performance was ascertained to be dismal. Import substitution and the growth puzzle As we have already discussed, the arrival of import substitution in Sri Lanka since the late 1950s took place in response to a number of internal and external forces. Given the contemporary world development thinking favouring import substitution and state intervention as well as the anti-colonial nationalist sentiments in political ideology in

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newly independent states, generally the establishment of an import substitution regime was easier and welcomed in Sri Lanka as elsewhere. However, the actual implementation of import substitution policies in an increasingly restrictive trade regime since the early 1960s came in response to worsened foreign exchange shortage rather than as a deliberate attempt for import substitution. Naturally, there were easy import substitution opportunities that could be exploited by both public and private sectors at the initial stage of the restrictive regime. The new policy environment created a protected incentive regime for channeling both public and private investment into industry. Therefore, it is clear that the growth performance in industry and in GDP reflected a moderate upward trend in the 1960s. When these easy import substitution opportunities in a small economy as Sri Lanka dried up within a relatively short period of time, naturally the upward trend in growth performance came to a critical halt. The tightened trade restrictions and the intensified state intervention initiated after 1970 further contributed to this end. In addition to the ideological premises of the government in power, the internal shocks (youth uprising in 1971) and the external shocks (oil price hike in 1973) made a substantial contribution to the choice of development strategies in the 1970s. The policy makers were, however, unable to see the fundamental issue at source because they continued to attribute poor growth performance in the restrictive trade regime to the frequent external shocks and steadily declining terms of trade. Primarily, it was the lack of growth performance, structural changes and export promotion, which made the Sri Lankan economy suffer seriously from the frequent external shocks and experience a steady decline in terms of trade. Terms of trade and growth The terms of trade movements of Sri Lanka during its post-independence development history reflected two important features. The first is the frequent sharp swings in terms of trade, which had an overwhelming impact on growth performance and policy choices, more in the restrictive than in the liberalized trade regimes. The second is the long-term declining trend of the terms of trade until the mid 1980s, followed by its relatively stable movement since then. This is a phenomenon associated directly with the choice of development strategy, because a significant change in the colonial export structure did not take place until the initiation of an export-oriented trade regime in 1977. Clearly, the terms of trade started to get stabilized with manufactured export expansion in the liberalized trade regime. There was clear evidence to suggest that the upward swings in terms of trade were often followed by a subsequent higher growth performance and, its downward swings by a lower growth performance more in the restrictive than in the liberalized trade regime. As a result, the policy makers had an easy time during the upward swings in terms of trade, during which domestic absorption was on the rise. Given the downward rigidity in domestic absorption, apparently, they had to undergo more difficult times when the downward swings in terms of trade came into being. This cyclical pattern of the terms of trade movements, therefore, required a gradual intensification of trade restrictions. If the favourable swings in terms of trade had been used to build the external reserves position, the trade deficits resulting from its downward swings could have been minimized and financed. Nevertheless, when the domestic absorption was downward rigid, the swings in

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terms of trade generated a pattern of boom and bust resulting in even more serious balance of payments crises (Athukorala and Jayasuriya 1994). This compelled the policy makers to find strategies to manage crises, when terms of trade swings were so sharp and frequent. Not only were the terms of trade shocks frequent, but also growth responses to these shocks were acute in the restrictive trade regime. One of the best comparisons is provided by the growth outcome between the period of the first and the second oil shock occurring respectively under the controlled and liberalized trade regimes. During the period of 1973-75 after the first oil shock, the terms of trade deteriorated on average by 14% per annum, while the average growth rate of GDP was 3.2% per annum. The impact of the second oil shock was even greater, recording a decline in the terms of trade on average by 23% during 1979-81; the average growth rate of GDP, however, remained at 6.0% per annum. The short-term swings and the long-term deterioration in the terms of trade in primary exporting countries have been a topical issue in the debate of trade strategy since the 1950s. If these problems continued to persist as long as the country remained a primary exporter, there was no question about the need for export promotion. In this context, it is important to ask why the policy makers were reluctant to accept this fundamental reality, and were compelled to continue with policies for managing crises rather than building the capacity to overcome crises. Export pessimism and export promotion Given the policy trust on import substitution and state intervention, and its success in large economies including the former USSR, it was difficult for policy makers to see a successful alternative strategy at the time. This was so not only for the SLFP governments, which actually forced the economy into a restrictive trade regime, but also for the UNP government, of which the basic trust was on a market-friendly policy regime. Since independence, the UNP too intervened in import substitution in agriculture, although it disengaged from industry (Gunatitillake 2000). When the UNP came into power for the second time in 1965, it was in the midst of an increasingly restrictive trade regime. Therefore, as we have discussed, the UNP government, not wishing to make drastic changes in the existing import substitution regime, appears to have been locked in a policy dilemma. Since the late 1960s, the policy makers have been inclined to take some measures for export promotion and diversification. This initiative was brought about in the restrictive trade regime under the UNP government, when it was confirmed that the heavy dependence on primary exports alone would not save the declining terms of trade, and would not meet the growing foreign exchange requirement. Given the competition in international markets dominated by the established industries of the developed countries, export promotion was not seen at the time as a viable development strategy for developing countries. On the contrary, there was also a greater need for export promotion. In spite of the fact that the expansion of traditional primary exports had already been limited by the land constraint, there was a belief that their productivity improvement would further diminish the export prices in the world market. If the promotion of either manufacturing exports or the traditional exports was not a viable solution, it was necessary to find alternative types of exports. Therefore, the exports

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promoted in the restrictive trade regime comprised minor agricultural crops (mainly spices), precious stones and other mineral resources, which were the types of commodities that could escape the competitive pressure in the international market. These industries were little different from the traditional export sector, and had no scope for expansion when compared to manufacturing production. Even under the UNP regimes in which agricultural development received priority, agriculture was never considered a potential export sector, but a subsistence sector that could save foreign exchange through self-sufficiency in food production. Although agricultural development received policy priority, there was little attempt for its modernization, which would have elevated agriculture from its subsistence level to a commercially viable production sector. Given the belief that in general, export promotion in manufactures takes time, short-term solution for the foreign exchange crisis should come from controls over import trade (Corea 1971). Therefore, a shift from import substitution to export promotion would further dampen the foreign exchange problem. The sum of short-terms constituted a long-term controlled regime, because the foreign exchange problem, however, worsened in each short-term without a breakthrough. Limited scope for learning by doing Learning that is acquired over time through experiments and experience has been important in guiding the process of policy making in developing countries. However, the governments of Sri Lanka were not prepared to admit the outcome of their own trial-anderror methods in a restrictive trade regime, because there were simple ways of avoiding the policy accountability. The first was that, as discussed earlier, generally the responsibility of a dismal economic performance could be passed on to the external shocks, which resulted in frequent terms of trade swings, in addition to the internal shocks (weather conditions and others). The second was the political swings governed by the five-year electoral schedule of the country, which always provided room for the successive governments to blame the previous one. This implied that a new government elected at the general elections had to bear the burden of the policy errors of the previous one providing a source of justification for new strategies. Since these strategies of the successive governments were designed within the existing policy framework, the policy cycle continued without a major breakthrough in the policy regimes. The most important implication of the governments lack of accountability has been that the political swings within a relatively short period of time provided little scope for the governments to learn from their own experience and to admit the outcome. Therefore, the basic trust on import substitution and state intervention continued for decades, since economic stagnancy and major problems were often interpreted as resulting from someone elses fault. Having confronted a series of external shocks and declining terms of trade, the successive governments in the restrictive trade regime were left with no other option than to tighten the controlled economy.

Trade Liberalization and Economic Growth

Generally, there is now little dispute over the fact that trade liberalization in Sri Lanka was accompanied by a higher growth performance, when compared to the dismal growth outcome of the restrictive trade regime. Nevertheless, over two decades of growth experience in the liberalized trade regime has shown the need to focus on a number of

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important puzzles. Although the liberalization episode was not considered to be a failure, it is worthwhile asking the question why it has failed so far to ensure the achievement of conditions for sustainable growth and stability. Timing and speed Among the South Asian economies, Sri Lanka has been the first country to embark upon policy reforms, while it has so far remained more liberalized than the others. It is equally important to note that, unlike in the other South Asian countries, the policy reforms in 1977 were driven, more than anything else, by the economic crisis in the previous regime that provided the required political mandate for liberalization. It was precisely this point that set the preconditions for trade liberalization in Sri Lanka, much earlier than in other South Asian countries. Despite being one of the smallest and trade-dependent economies in South Asia, import substitution and state intervention were quite intensive in Sri Lanka, which had converted the country into one of the highly controlled economies in the world, outside the socialist bloc. Therefore, by the mid 1970s, Sri Lankas economic and political environment had already become more conducive for trade liberalization than anywhere else in the South Asian region. It is, however, impossible to overlook the repercussions of the previous policy regime. The liberalization episode of Sri Lanka confirmed the fact that the longer and deeper the import substitution and state intervention adopted in a small economy, the greater will be the economic and political cost of adjustment to policy reforms. Therefore, liberalization was apparently accompanied by intense adverse effects on the patterns of production, fiscal operations and balance of payments, which had got established over a long period of time. The potential economic and political costs of adjustment, at least to a certain extent, caused subsequent reversals and delays in policy reforms. Because it was difficult to eliminate some of the elements of the previous controlled economy within a short period of time, trade liberalization was not accompanied by complementary measures as a comprehensive policy package. Against this background, it is difficult to reject the notion that the policy reversal in 1970 in moving the economy from a mini-liberalized regime to a highly controlled one was a turning point. It is true that the economic and political environment in 1970 had not constituted preconditions for liberalization. However, the move from a soft phase of import substitution to one of its hard phases in that year had imposed a massive cost of adjustment to liberalization, when it came seven years later. A complete re-orientation of the economy naturally resulted in adverse effects on established production and employment patterns and in adverse movements in macroeconomic fundamentals. Moreover, the post-1977 policy reforms took place in a more difficult time in intensifying the costs of adjustment. Interestingly, trade liberalization came in between massive upward and downward swings in terms of trade that the country had hardly experienced throughout the post-independence history. The terms of trade improved by 72% during 1976-77, while it deteriorated by 54% during 1979-81. Unfortunately, the sequence of these events, with trade liberalization in between, had an adverse impact on the macroeconomic fundamentals. The rise in domestic absorption against trade liberalization was facilitated further by the improvement in terms of trade prior to that. Followed by this, given the downward rigidity in domestic absorption, the decline in

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terms of trade produced even more serious balance of payment problems than what could have been otherwise in forcing policy reforms to go through a difficult pace. Even in the case of civil wars of the country, trade liberalization was considered to be a delayed programme. The economic causes of the countrys political conflict were rooted more in the restrictive regime than in the liberalized regime (Abeyratne 1998). With higher growth performance, the generation of employment and income with the expansion of labour-intensive industry has been much greater in the liberalized trade regime than in the pre-1977 stagnant economy, where people were compelled to share poverty and forced to compete on scarce opportunities. Countries like Malaysia, which never had a highly controlled economy as such, succeeded in achieving sustainable growth momentum and, consequently avoided potential political conflict in plural societies (Athukorala 2001, Bruton 1992, Snodgrass 1995). Trade liberalization in Sri Lanka was too late, in a sense that it had an inadequate time span to neutralize the fertile ground for political conflict that had been already nurtured in the restrictive trade regime. An analysis of the economic consequences of the concurrent twin civil wars (in the South among the Sinhala community and in the North among the Tamil community) has provided a straightforward and partial explanation to the growth turbulence and macroeconomic instability in the liberalized trade regime. On the one hand, it kept extending the period of recovery from the initial macroeconomic instability and the cost of adjustment to policy reforms. On the other hand, it disrupted the newly emergent investment climate of the economy by ending the initial investment boom and capital inflows. Both factors, associated strongly with the civil war, retarded the growth momentum and exacerbated the macroeconomic instability, from which the economy could not escape throughout the subsequent period. The outbreak of civil wars in the mid 1980s gave no time for the economy to get adjusted to the initial disruption of the production pattern established under protective barriers. The fiscal turbulence caused by the initial upsurge in public investment and the disarray in balance of payments was further aggravated by the adverse impacts of the civil wars. The worst came much later, as public debt rose to the level of GDP, and defense and interest payments alone consumed about 40% of government expenditure in the 1990s. Macroeconomic stability and growth From a glance at the indicators pertaining to the internal and external balance of Sri Lanka, one would immediately note that the macroeconomic stability in the restrictive trade regime was greater than that in the liberalized trade regime. In the restrictive trade regime, the trade deficit was less than even 5% of GDP for most years, so that without depending on capital inflows, the balance of payments deficit was kept at minimum levels. The budget deficit too was low and remained around 6% of GDP for most of the time. It was also a low inflationary regime in which the average rate of inflation was only about 4% during 1960-1977. Compared to the macroeconomic stability in the restrictive trade regime, the period of liberalization was highly turbulent. The massive increase in trade deficit could not have been contained unless there were increased capital flows and private remittances. An upsurge in the budget deficit forced the government to rely on both domestic and foreign borrowings. The rate of inflation remained at a double-digit level, particularly during 1977-1984 and 1988-1993.

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Stability between controlled and liberalized regimes The devastating differences in growth performance between the restrictive and the liberalized trade regimes were not directly attributable to the differences in macroeconomic stability. The stability in macroeconomic fundamentals in the restrictive trade regime was achieved forcefully through controls. The controls themselves weakened the growth performance, which had a spiral impact on macroeconomic policy. In addition, the policy makers, guided by the pro-distributive sentiments in economic policy, were not prepared to compensate the stability for growth even in the short-run. However, since economic growth itself was a fundamental requirement of macroeconomic stability, the restrictive trade regime reflected a low level equilibrium position of the economy without a breakthrough in it. Even though the macroeconomic stability was shaken with policy reforms, the growth performance generally remained greater in the liberalized trade regime than in the restrictive trade regime. Nevertheless, within the liberalized trade regime, there have been different patterns of maintaining the macroeconomic fundamentals, which had implications on growth performance. Particularly, the policy emphasis on maintaining the fiscal balance was greater in the second phase of trade liberalization after 1989, than in its first phase after 1977. Was this difference a matter of importance in explaining the growth performance and export promotion in the two respective phases? And was there a reverse causation running from growth performance to macroeconomic stability? Stability after the first wave of policy reforms Naturally, the non-tradable sector responded quickly to the first wave of policy reforms in 1977. This was buttressed by the large influx of official foreign capital, combined with a corresponding increase in public expenditure on politically appealing large infrastructure projects, resulting in massive budget deficits. The rise in budget deficits was further contributed to by the increased transfer payments to the inefficient public enterprises, which faced a hard time with import liberalization and currency depreciation. The cut backs in consumer subsidies had a marginal impact on fiscal balance. Thus, enhanced growth performance in the initial period of trade liberalization could be attributed more to the expansion of the non-tradable sector than to the export performance. In fact, the potential export growth was further undermined by the antiexport bias in trade policy and the real appreciation of the exchange rate in the 1980s. Therefore, trade deficit continued to grow but the balance of payments was maintained through other forms of foreign exchange inflows. With regard to the issue that led to such a policy choice, the emphasis on political priorities over economic priorities cannot be ignored. On the part of the government, there was a belief that the sudden influx of foreign funds needed to be utilized before they got dried up, in order to achieve tangible results quickly (Athukorala and Jayasuriya 1994). The political history of Sri Lanka has provided ample evidence on the cyclical pattern of change in the electoral popularity of the ruling parties. Thus, the achievement of quick results was necessary to stabilize the political regime, which was already disrupted by the political leadership moving away from traditional political pluralism. The attention of the government as well as of the people was, thus, captured by politically appealing public investment projects. Moreover, the government that was already faced with unpleasant economic and political costs of adjustment to policy and political reforms later appears to have been

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reluctant in reducing its fiscal burden and aggressively advancing the export drive. If the temporary rise in income and employment through the expansion of the non-tradable sector had been converted to a permanent rise by achieving potential export growth, it would have subsequently contributed to the maintenance of both internal and external balances. Given the crisis driven nature of the policy reforms, despite its rhetoric, the liberalized trade regime did not have the characteristics of a consistent policy package for achieving sustainable export expansion and economic growth. Stability after the second wave of policy reforms Evidently, the economy did not recover subsequently from the initial macroeconomic imbalances mainly due to two factors. The first is that much of the burden of the initial macroeconomic instabilities, as well as reversals and delays in policy reforms, gradually fell on the latter stages of the liberalized trade regime. Large amounts of borrowings from both domestic and foreign sources to finance the increased budget deficits had accumulated by the end of the first phase of liberalization. In the pace of the slowing down growth performance since the mid 1980s, the maintenance of the fiscal prudence and balance of payments equilibrium became an onerous exercise for the policy makers. The second is the new dimensions of public expenditure, such as military and welfare expenditures, added to the fiscal deficit. Even with increased current expenditure, the governments in the 1990s were concerned with reducing the budget deficit. Although the privatization programme had a positive impact on this, much of the burden of reduced budget deficits fell on capital expenditure. In response to the second wave of policy reforms, growth performance and export expansion improved in the first half of the 1990s, but did not show outstanding results in the second half of the 1990s. If there was policy emphasis on reducing the budget deficit throughout the 1990s, it is an important question to consider why there was a difference in growth performance between the first and the second halves of the decade. Clearly, the issue cannot be analyzed on the basis of policy factors alone, since, as discussed, the differences in political factors, including the political leadership, between the periods of 1989-1994 and 1994-2000 also played a major role. However, the policies after 1989 were directed at both fiscal prudence and export promotion, among other things. But, when the policy makers struggled with achieving only fiscal prudence, export expansion slowed down and the external finance position deteriorated in the second half of the 1990s. This experience showed that fiscal prudence alone was not a sufficient condition for achieving a sustainable growth momentum, while in the absence of rapid economic growth, both internal and external stability came under pressure.

Political Economy of Growth Performance

The choice of policy as well as the efficiency of the policy chosen, is determined by the context of the political economy in which an economic system is in operation. The political economy is a part of the institutional framework of a country, comprising the manmade rules that condition the behaviour of actors such as individuals, institutes, interest groups, pressure groups, semi-political organizations, political parties and governments. Because the rules of the political economy constrain, regulate, facilitate, and coordinate the behaviour of economic agents, there are divergences in the results of the same policies implemented in different countries, or in different contexts.

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In the analysis of policy responses, we have focussed on the countrys political economy that influenced the governments policy choices and the growth responses of the policies implemented. The pluralistic and competitive political system, the extensive social welfare system, and the legislative system of a social democratic orientation, are some of the initial conditions that formed the rules of the game in the postindependence development history. They were of importance in conditioning the policy choice and historical growth performance. Were their changes in the backdrop of the policy reforms necessary for higher growth performance in the liberalized trade regime? Were these changes sustainable in laying the foundation for long-term economic growth? Has the liberalization episode been accompanied by adequate changes in the political economy to ensure rapid economic growth in the long run? These are some of the fundamental issues that require an analysis in a discussion on the political economy of growth performance. The post-independence history of Sri Lanka has provides evidence to suggest that democracies organized within such political institutions, as those prevalent in Sri Lanka, would grow slowly, if not, tend to stagnate. Simply, the reason is that decisionmaking is subject to the influence of political institutions, and that the government is not strong enough to enforce cohesive decisions, based on a long-term policy vision. A radical shift from a highly controlled economy towards a liberalized one, though, driven by the crisis, may seem easier at its initial stage, might be constrained or even reversed by the political institutions at a latter stage. The constitutional reforms were considered to be a major step towards the adjustment of the institutions. Despite that, most of the evidence confirms that the leadership made a direct attempt to exercise control over the institutions, wishing to see an end of the political and policy swings, a silence of dissent and resistance, and a stability of the power and authority. It is however, difficult to suggest that the power and authority of the leadership was exercised over all areas of concern, ignoring the potential threat that it could have posed. For instance, privatization was excluded from the initial implementation programme, although its delay against trade liberalization contributed to massive fiscal deficits through increased transfer payments. In addition, the politically appealing lead projects received high priority, with the anticipation of tangible quick results that would have helped in stabilizing the political regime. Even though the new opportunities and the material gain in the liberalized regime created high expectations of prosperity, the growing political turmoil and civil wars weakened the power and authority of the government. There were also growing criticisms and controversies over the authoritarian method of rule, political violence, escalating corruption, deteriorating human rights and, the emerging type of crony capitalism. In addition, the growing tensions within the UNP itself contributed to the deterioration of its political regime. Nevertheless, the continuation of the rule of the UNP government for seventeen years under strong leadership and weakened opposition apparently had a devastating impact on the establishment of the liberalized trade regime in the country. It provided an adequate time span, on the one hand, for the establishment of institutions in a liberalized trade regime, and on the other hand, for alternative political forces to realize the gains of trade liberalization. The leadership of the UNP regime succeeded only in delaying political swings, but not in ending them. Nevertheless, during this period, trade liberalization had

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become the bipartisan policy of the country, in bringing about an end to the historical policy swings. The appeal for political consensus on policy, among other national issues, has however become more crucial today than ever before, as a result of constitutional changes in 1978. The Constitution has ensured a wider representation of minor political parties affecting the dominant position of the major parties in the government, and placed a heavy reliance on the political will of the head of the state, the Executive President. Therefore, on the one hand, charismatic leadership matters more than ever before in the simplified decision-making process. In fact, it was under a strong leadership that the UNP continued to be in power for seventeen years, while the UNP regime collapsed with its leadership. On the other hand, although the head of the state had become quite stable as the Executive President, the governments had become highly unstable. As the two dominant political parties (the UNP and the SLFP) are almost not in a position to form their own strong governments any longer, they are compelled to seek the participation of minor political parties in the decision-making process. Therefore, minor parties have not only increased their representation in parliament, but also obtained a greater bargaining power. Although the new political setup could be viewed as a move forward along the democratic lines, it has also posed a major challenge. The system requires a wider political consensus for political stability and decision-making, affecting economic growth.

V. Conclusion
The focus of this study was on an analysis of the growth performance of Sri Lanka during the past fifty years (1950-2000) and the major growth puzzles. The analysis was based on an investigation of growth response to economic policies between and within different trade regimes. The patterns of growth response to policy were explored on the basis of a series of macroeconomic data for the period under consideration. A study on growth performance involved a greater degree of attention on the institutional factors within the political economy that constituted the choice of policies and that conditioned the growth outcome of the policies. At the time of gaining independence in 1948, Sri Lanka had inherited from its colonial past some distinctive, unique features setting an initial advantageous position in economic, social and political spheres and favouring an achievement of sustainable rapid economic growth. Despite initial optimism in the development success of the country, the growth performance fell short of the potentials and the standards required in maintaining its economic and political stability, as well as the welfare state.

Policy Regimes and Growth Performance

On the basis of economic and political ideology governing the choice of development policies and the policy outcome, the post-independence development history of Sri Lanka can be divided into three major phases: 1948-1956 with a continuation of the colonial free-market economy, 1956-1977 that shows a gradual intensification of the policies of import substitution and state intervention and, 1977-2000 as the liberalized trade regime. However, there were interludes and variations in policy within these phases, which were governed by a number of factors. The most important among these were the initial
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conditions set by the political regimes changed frequently at the general elections, the contemporary development thinking and practice in the world economy, the internal and external shocks in the respective periods and, the rules set by the countrys political economy. There is little dispute over the fact that growth performance in the post-1977 liberalized trade regime was greater than that in pre-1977 restrictive trade regime. However, there are some important features associated with the long-term growth performance and its short-term fluctuations within each of the policy regimes. Having failed in exploiting the initial advantageous position, the economy entered into a stage of deep and prolonged stagnancy during the period until 1977, covering the first and the second policy regimes. However, together with an expansion in manufacturing production, the growth of GDP shows a moderately upward trend in the initial phase of import substitution in the 1960s. This reflected the result of the exploitation of easy import substitution opportunities, which dried up quickly through market constraints in a small economy and the policies of a highly controlled regime prevalent during 1970-77. The initial phase of trade liberalization had resulted in a substantially higher growth performance, led more by an unprecedented expansion in construction and service sectors, than by manufacturing growth. The mid 1980s were marked by an important turning point as the trend of GDP growth started to reflect the growth of the manufacturing sector together with a steady rise in the share of manufacturing in GDP, and a rapid expansion in the export of labour-intensive manufactures. However, the growth performance and export promotion in the liberalized trade regime did not reflect a consistency, since they were closely linked to the divergences in economic policies and macroeconomic stability, the outbreak of civil wars and, the changes on the political front. Even with relatively higher average growth performance, the evidence suggests that the country had not yet set the conditions for sustainable growth and stability by the turn of the century.

Growth Puzzles
The major growth puzzles that emerged from the Sri Lankan experience were centered on three main issues. First, why did Sri Lanka fail in exploiting its favourable initial conditions, which actually constrained rather than facilitated the achievement of a sustainable growth momentum? Given the economic, social, political and other factors that constituted the favourable initial conditions and the rules of the political economy of policy-making, there was little accumulation of investment capital from the prosperous primary exports, in both private and public sectors. When the initial economic prosperity of a trade-dependent economy disappeared with adverse movement of the terms of trade, the policy makers gradually got interlocked within their policy framework that did not favour accumulation and investment. The second major puzzle is why did import substitution and state intervention continue for so long with gradual intensification, even when the growth performance was confirmed to be poor? The controlled trade regime, which was initiated in response to balance of payments problems, was consistent with the anti-colonial nationalist sentiments in economic and political ideology, as well as with contemporary development thinking and practice in most parts of the world. However, the potential drying up of easy import substitution opportunities within a short period of time in a

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small economy was never recognized at policy level. The prevalent export pessimism in economic ideology was imperative for ignoring the possibilities of export promotion. Internal and external shocks were instrumental in tightening the trade controls and in expanding the role of the state, as well as in attempting to achieve redistributive justice. Moreover, there was little scope for policy makers to learn from trial and error, since the frequent policy and political swings as well as the frequent terms of trade swings often provided an easy way of escaping from accountability in policy-making. The policy makers thus, failed to address the fundamental problem at its source and hence, were more inclined to formulate policies to manage the crises than to achieve a sustainable growth momentum. Finally, even with a remarkably high average economic growth, why did Sri Lanka experience inconsistent growth performances and worsened macroeconomic instabilities in its liberalized trade regime? The preconditions for trade liberalization appeared in Sri Lanka earlier than in other South Asian countries, through the economic crisis in the last phase of the controlled regime. However, trade liberalization had gone through the most turbulent period in the history of the country, resulting from macroeconomic instabilities and the political upheavals, influencing the policy choices and growth performance. The Sri Lankan experience with policy reforms confirmed the fact that the longer and deeper the continuation of import substitution and state intervention in a small economy, the greater will be the economic and political costs of adjustment. In this sense, trade liberalization in Sri Lanka was already a delayed process, while within the process itself there were reversals and further delays in policy reforms. The sequence of a number of events at the initial stage of trade liberalization exacerbated internal and external imbalances, retarding the growth momentum and weakening the governments ability to maintain stability. Given the downward rigidity in domestic absorption, trade liberalization that came in between massive upward and downward swings in terms of trade, exerted pressure on balance of payments that had to be compensated by increased capital flows and remittances. Massive upsurge in public investment combined with the influx of official capital flows and the delays in the rationalization of government expenditure exerted pressure on fiscal balance. As a consequence of the governments expenditure pattern and the private sectors response to the policy reforms, the initial growth momentum was assisted more by the expansion of the non-tradable sector than by export-oriented production. The initial macroeconomic instability never reversed as the twin civil wars (in the South and in the North) erupted in the mid 1980s, giving no time for the country to recover the stability. The outbreak of civil wars resulted in a deterioration of the investment climate by ending the achievement of potential economic growth, and dragged the burden of the initial macroeconomic instability throughout the subsequent period.

Policy Lessons and Challenges

By rejecting the fact that the Sri Lankan economy was greatly tied up with the international economy, the fundamental issue of growth was not addressed at source for three decades after independence. When this fact was realized at policy level, the country had missed the trade opportunities that the international market would have otherwise offered for gaining growth momentum.

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The analysis on the growth performance suggests that the continuation of growth-constraining policies were more important than a direct tradeoff between growth and welfare, in explaining the poor growth performance of the restrictive trade regime. This does not, however, rule out the implications of the attempt to achieve redistributive justice in a stagnant economy through an extensive welfare system. To a great extent, it set the rules of the game, which made the policy makers interlocked in undermining the policy priority for long-term growth and stability. It is often argued that, being a highly trade-dependent economy, Sri Lankas growth performance continued to be hindered by the short-term swings and long-term deterioration of the terms of trade. An analysis of growth experience supports a reverse causation running from export promotion to the behaviour of terms of trade and, from growth performance to the degree of vulnerability to terms of trade shocks. The macroeconomic stability, which was maintained through stringent controls in the restrictive trade regime, received priority in policy-making and was governed by the fear of market forces and of pro-distributive attitudes. In the liberalized trade regime, different scenarios of maintaining macroeconomic stability and growth performance could be observed. The internal and external imbalances deteriorated substantially during the initial phase of policy reforms in 1977, constraining the expansion in the tradable sector, but favouring demand-propelled expansion mostly in the non-tradable sector. The question of how the economy recovered from these initial macroeconomic instabilities remains unanswered since the economy never recovered, due to the eruption of the civil wars. Evidence suggests that not only the macroeconomic stability is important for achieving a sustainable growth momentum, but also growth itself is necessary to maintain the stability. Policy reforms in 1977 were accompanied by political reforms in order to establish a liberalized trade regime within a supportive political atmosphere, where the decision-making process was simplified and the power and authority of the political leadership was guaranteed in the long run. The dual process of reforms was taken as necessary and complementary, as the short-term policy and political cycles and the weak decision-making power of the government had hindered the potential growth performance of Sri Lanka in the past. Despite constitutional reforms in 1978, much of the effort on the political front appears to have been concentrated more on direct control over the established institutions than on institutional reforms. Without reforming the rules that conditioned the behaviour of economic agents, the direct controls over institutions were not permanent, as they collapsed with the regime. However, the continuation of a single political regime for seventeen years in a near authoritarian style has been instrumental in getting the liberalized trade regime established and in recognizing it as a bipartisan policy. However, as a result of the new political structure created by the 1978 Constitution, the role of the Executive Head of the state and the need for broad political consensus have become more important than ever before in respect of both policy choices and political stability favouring economic growth. Even while coping with economic and political costs, Sri Lanka has recorded a remarkable growth performance in its liberalized trade regime. Nevertheless, there were many gray areas of policy reforms, particularly due to their incompleteness and inconsistency. Besides reforms in policies for trade liberalization, they were not accompanied by purposive and fundamental changes in institutions relating to market

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regulations, the public sector, the role of the state, and the political structure consistent with policy reforms. What Sri Lanka needs at its current juncture of the growth process is a challenge. The country has to recover from the deep-rooted macroeconomic problems and political problems, which are interrelated with growth performance. A rapid pace of transition is necessary, with enhanced export promotion and economic growth, supported by broad-based purposive institutional reforms.

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Statistical Appendix
Appendix 1 Demographic Transition 1950-2000 Mid year population (1000s) 7544 7742 7940 8098 8385 8589 8929 9165 9388 9625 9896 10168 10443 10582 10903 11164 11439 11703 11992 12252 12514 12690 12861 13091 13284 13496 Mid year growth rate (%) 3.3 2.6 2.6 2.0 2.8 2.4 3.9 2.6 2.4 2.5 2.8 2.7 2.7 1.3 3.0 2.4 2.5 2.3 2.5 2.2 2.1 1.4 1.3 1.8 1.5 1.6 Age composition (%) Less than Between Over 64 Birth rate Death rate Infant 20 years 20-64 years (per 1000) (per 1000) mortality years (per 1000) 47.4 49.1 3.5 40.5 12.6 82 47.5 49.1 3.4 40.5 12.9 82 47.4 49.1 3.5 39.5 12.0 78 47.8 48.7 3.5 39.4 10.9 71 47.4 49.1 3.4 36.2 10.4 72 47.5 49.1 3.5 37.3 11.0 71 48.4 48.1 3.5 36.4 9.8 67 50.4 47.8 1.9 36.5 10.1 68 50.4 47.8 1.9 35.8 9.7 64 49.9 48.8 1.4 37.0 9.1 58 50.4 47.7 1.9 36.6 8.6 58 50.4 47.7 1.9 35.8 8.0 52 50.3 47.8 1.9 35.5 8.5 53 51.1 44.6 4.2 34.1 8.5 56 51.6 44.8 3.6 33.2 8.8 57 51.6 44.8 3.6 33.1 8.2 53 51.6 44.8 3.6 32.3 8.3 54 51.6 44.8 3.6 31.6 7.5 48 51.6 44.8 3.6 32.0 7.9 50 51.6 44.8 3.6 30.4 8.1 53 51.6 44.8 3.6 29.4 7.5 48 49.7 46.1 4.2 30.4 7.7 45 49.7 46.0 4.3 30.0 8.1 46 49.7 46.0 4.3 28.0 7.7 46 49.7 46.0 4.3 27.5 9.0 51 49.7 46.1 4.2 27.8 8.5 45 Continued

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975

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Continued Mid year Mid year population growth (1000s) rate (%) 1976 13717 1.6 1977 13912 1.6 1978 14190 1.8 1979 14472 2.0 1980 14747 1.9 1981 14847 0.7 1982 15196 2.3 1983 15417 1.5 1984 15603 1.2 1985 15842 1.5 1986 16127 1.8 1987 16373 1.5 1988 16599 1.4 1989 16825 1.4 1990 17015 1.1 1991 17267 1.5 1992 17426 0.9 1993 17646 1.3 1994 17891 1.4 1995 18136 1.4 1996 18336 1.1 1997 18552 1.2 1998 18774 1.2 1999 19043 1.4 2000 19359 1.7 Note: data not available. Source: CBSL (2000) Age composition (%) Less than Between Over 64 Birth rate Death rate Infant 20 years 20-64 years (per 1000) (per 1000) mortality years (per 1000) 49.7 46.1 4.2 27.8 7.8 44 49.8 46.2 4.1 27.9 7.4 42 49.7 46.1 4.2 28.5 6.6 37 49.7 46.1 4.2 28.9 6.5 38 49.7 46.1 4.2 28.4 6.2 34 47.4 47.7 4.9 28.2 5.9 30 46.1 49.6 4.3 26.9 6.1 31 46.1 49.6 4.3 26.3 6.2 28 46.1 49.6 4.3 25.1 6.5 27 46.1 49.6 4.3 24.6 6.2 24 46.0 49.7 4.3 22.4 6.0 23 46.0 49.7 4.3 21.8 6.0 23 46.0 49.7 4.3 20.7 5.8 20 46.0 49.7 4.3 21.6 6.3 18 45.9 49.6 4.4 20.1 5.8 19 45.9 49.6 4.4 21.6 5.5 17 45.9 49.6 4.4 20.1 5.6 18 45.9 49.6 4.5 19.9 5.3 16 45.9 49.6 4.4 19.9 5.6 17 45.9 49.6 4.4 18.9 5.8 17 45.9 49.6 4.4 18.6 6.7 17 46.0 49.7 4.3 17.9 6.1 16 46.0 49.7 4.3 17.3 5.9 14 46.0 49.7 4.3 17.3 6.0 46.0 49.7 4.3

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Appendix 2 Parliamentary Elections and Post-Independence Governments of Sri Lanka UNPa SLFPb Election Government Seats % Seats % 1947 UNP 42 44.2 1952 UNP 54 56.8 9 9.5 1956 SLFP-led coalition (MEP) 8 8.4 51c 53.7 1960 (Mar) UNP-led coalition 50 33.1 46 30.5 1960 (Jul) SLFP 30 19.9 75 49.7 1965 UNP-led coalition 66 43.7 41 27.2 1970 SLFP-leftist coalition (UF) 17 11.3 116d 76.8 1977 UNP 140 83.3 8 4.8 1989 UNP 125 55.6 67 29.8 1994 SLFP-led coalition (PA) 95 42.2 105e 46.7 47.6 2000 SLFP-led coalition (PA) 89 39.6 107e 2001 UNP-led coalition (UNF) 109f 48.4 77 34.2 a: UNP (United National Party, founded in 1946) b: SLFP (Sri Lanka Freedom Party, founded in 1951) c: Number of seats obtained by the MEP (Mahajana Eksath Peramuana) d: Number of seats obtained by the UF (United Front) e: Number of seats obtained by the PA (Peoples Alliance) f: Number of seats obtained by the UNF (United National Front) Source: CBSL (2000) and ANCL (various issues)

Others Seats 53 32 36 55 46 44 18 20 33 25 29 24

% 55.8 33.7 37.9 36.4 30.5 29.1 11.9 11.9 14.7 11.1 12.9 10.7

Total 95 95 95 151 151 151 151 168 225 225 225 225

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Appendix 3 Production and Productivity 1950-2000 Appendix 3 (a) Growth Rate of Real GDP 1951-2000 (%) Agriculture Mining & Manufacturing quarrying 1951 9.1 2.7 -1.8 1952 3.7 2.7 0.2 1953 -0.9 2.9 -0.5 1954 5.3 0.0 1.0 1955 5.0 13.2 6.2 1956 -4.6 27.7 -2.1 1957 0.6 -1.7 3.6 1958 2.3 -7.5 7.0 1959 -1.0 -7.9 2.0 1960 5.8 3.2 6.7 1961 7.4 0.0 2.5 1962 3.1 3.1 7.0 1963 5.6 -9.1 6.9 1964 3.5 6.7 5.6 1965 -5.9 6.3 4.0 1966 1.7 8.6 7.6 1967 8.5 0.0 4.4 1968 5.8 0.0 9.7 1969 1.3 46.0 9.3 1970 3.8 20.3 5.6 1971 -2.4 1.1 3.7 1972 3.1 7.3 1.8 1973 -0.8 358.0 -2.4 1974 5.8 -37.5 -4.5 1975 -2.4 33.9 4.6

Construction 22.1 20.4 1.9 -8.9 11.5 31.5 -6.0 -7.6 -8.5 -0.7 -4.3 4.8 -3.5 4.0 -6.0 10.1 19.8 30.5 10.0 14.5 -4.8 -8.1 2.2 7.1 -8.8

Services 5.2 4.7 3.8 2.6 5.8 1.3 2.3 3.6 3.2 8.5 -1.8 5.3 -0.1 9.7 9.9 3.9 1.6 7.8 5.5 2.8 1.0 4.9 3.1 6.6 4.8

GDP 6.2 4.6 1.9 2.7 5.9 0.7 1.5 2.9 1.5 6.7 2.1 4.6 2.8 6.4 2.3 3.8 5.1 8.2 4.8 4.3 0.2 3.2 3.7 3.2 2.8 Continued

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Continued Agriculture 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: CBSL (2000) 1.2 10.4 5.4 2.0 3.1 6.9 2.6 5.0 -0.4 8.6 2.6 -5.8 2.1 -1.1 8.5 1.9 -1.6 4.9 3.3 3.3 -4.6 3.0 2.5 4.5 1.8 Mining & quarrying 44.6 -9.8 20.2 5.3 4.9 4.2 4.1 7.8 1.5 1.5 5.2 19.0 9.0 5.4 9.1 -10.0 -6.0 11.9 6.0 3.4 8.9 3.8 -5.4 4.1 4.8 Manufacturing 4.8 -0.6 7.8 4.6 0.8 5.2 4.8 0.8 12.3 5.2 8.4 6.8 4.7 4.4 9.5 6.8 8.8 10.5 9.1 9.2 6.5 9.1 6.3 4.4 9.2 Construction 5.5 -9.6 28.3 20.9 11.0 -3.0 -2.0 1.0 -0.1 0.5 1.5 1.8 1.5 0.6 2.9 3.1 8.1 6.5 6.0 4.9 3.4 5.4 7.1 4.8 4.8 Services 1.0 4.8 7.6 7.8 8.0 6.4 7.0 6.7 7.0 3.9 4.3 2.7 2.2 3.2 4.3 6.2 5.3 6.3 5.2 5.1 5.8 7.1 5.2 4.2 6.9 GDP 3.0 4.2 8.2 6.3 5.8 5.8 5.1 5.0 5.1 5.0 4.3 1.5 2.7 2.3 6.2 4.6 4.3 6.9 5.6 5.5 3.8 6.3 4.7 4.3 6.0

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Appendix 3 (b) Composition of GDP 1950-2000 (%) Agriculture Mining & Manufacturing quarrying 1950 42.4 0.3 12.0 1951 43.2 0.3 11.0 1952 42.7 0.3 10.5 1953 41.9 0.3 10.4 1954 43.0 0.3 10.2 1955 42.6 0.3 10.2 1956 40.3 0.4 9.9 1957 40.2 0.4 10.2 1958 40.2 0.3 10.6 1959 39.6 0.3 10.8 1960 39.4 0.3 10.8 1961 41.4 0.3 10.9 1962 40.8 0.3 11.1 1963 42.0 0.2 11.6 1964 40.9 0.2 11.5 1965 37.8 0.3 11.8 1966 37.0 0.3 12.2 1967 38.0 0.3 12.0 1968 37.0 0.2 12.1 1969 35.7 0.3 12.6 1970 35.5 0.4 12.8 1971 34.7 0.4 13.3 1972 34.9 0.4 13.2 1973 33.8 1.8 12.6 1974 34.3 1.1 11.5 1975 33.0 1.4 11.9

Construction 6.4 7.3 8.3 8.4 7.4 7.8 10.2 9.5 8.6 7.8 7.3 6.8 6.9 6.4 6.3 5.8 6.2 7.0 8.4 8.8 9.7 9.2 8.3 8.2 8.5 7.6

Services 38.9 38.2 38.1 39.1 39.1 39.1 39.2 39.8 40.3 41.4 42.2 40.6 40.9 39.8 41.0 44.3 44.3 42.7 42.2 42.5 41.8 42.4 43.3 43.6 44.6 46.1

GDP 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Continued

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Continued Agriculture 1976 32.6 1977 34.5 1978 33.5 1979 32.1 1980 31.3 1981 31.7 1982 31.1 1983 31.1 1984 29.6 1985 30.6 1986 30.2 1987 28.2 1988 28.0 1989 27.2 1990 27.8 1991 27.1 1992 25.7 1993 25.2 1994 24.7 1995 24.3 1996 22.4 1997 21.7 1998 21.3 1999 21.3 2000 20.5 Source: CBSL (2000) Mining & quarrying 2.0 1.7 1.9 1.9 1.8 1.8 1.8 1.9 1.8 1.7 1.8 2.1 2.2 2.3 2.3 2.0 1.8 1.9 1.9 1.9 2.0 2.0 1.8 1.8 1.7 Manufacturing 12.2 11.6 11.5 11.3 10.8 10.7 10.8 10.3 11.1 11.1 11.5 12.2 12.5 12.8 13.2 13.5 14.1 14.6 15.1 15.7 16.2 16.6 16.9 16.9 17.4 Construction 7.8 6.8 8.0 9.1 9.5 8.8 8.2 7.9 7.6 7.2 7.0 7.1 7.0 6.9 6.7 6.6 6.9 6.9 6.9 6.9 6.9 6.9 7.0 7.1 7.0 Services 45.4 45.5 45.1 45.7 46.6 47.0 48.1 48.8 50.0 49.4 49.5 50.4 50.2 50.8 50.0 50.8 51.5 51.3 51.3 51.2 52.4 52.8 53.1 53.0 53.4 GDP 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100

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Appendix 3 (c) Estimate of Total Factor Productivity Growth (TFPG) 1980-88 (annual compound growth rates) dV dL dK Vsk 31 Food, beverages and tobacco 32 Textile, wearing apparel and leather 33 Wood, wood products and furniture 34 Paper, printing and publishing 35 Chemicals, petroleum, rubber and plastic 36 Non-metallic mineral products 37 Basic metal industries 38 Fabricated metal, machinery and equipment 39 Other manufacturing industries Total 15.65 12.12 7.61 5.71 -5.34 2.04 -9.46 0.33 32.47 7.26 6.54 6.51 3.08 -1.42 -0.84 -0.78 -7.29 -3.63 17.95 3.45 16.51 7.57 18.78 -5.49 -17.86 -4.57 -7.68 4.05 5.46 0.01 0.90 0.62 0.60 0.58 0.80 0.58 0.56 0.78 0.73 0.79

Vsl 0.10 0.38 0.40 0.42 0.20 0.42 0.44 0.22 0.27 0.21

dL.Vsl dK.Vsk 0.63 2.50 1.24 -0.60 -0.16 -0.33 -3.19 -0.79 4.82 0.72 14.93 4.67 11.20 -3.18 -14.37 -2.65 -4.32 3.17 4.00

TFPG 0.10 4.95 -4.83 9.48 9.19 5.01 -1.95 -2.05 23.65

0.01 6.53 Continued

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Continued Estimate of Total Factor Productivity Growth (TFPG) 1988-94 (annual compound growth rates) dV dL dK Vsk Vsl dL.Vsl dK.Vsk TFPG 31 Food, beverages and 10.08 9.01 -2.15 0.92 0.08 0.71 -1.98 11.34 tobacco 32 Textile, wearing 29.34 21.50 19.65 0.69 0.31 6.62 13.59 9.13 apparel and leather 33 Wood, wood products 4.31 1.61 -8.82 0.71 0.29 0.47 -6.25 10.09 and furniture 34 Paper, printing and 13.30 6.54 4.24 0.65 0.35 2.28 2.76 8.26 publishing 35 Chemicals, petroleum, 19.38 11.21 25.21 0.79 0.21 2.33 19.98 -2.93 rubber and plastic 36 Non-metallic mineral 14.74 6.72 35.51 0.71 0.29 1.93 25.34 -12.53 products 37 Basic metal industries 48.41 4.61 0.35 0.75 0.25 1.15 0.26 46.99 23.74 15.38 13.25 0.80 0.20 3.14 10.54 10.06 38 Fabricated metal, machinery and equipment 39 Other manufacturing 34.38 32.71 31.07 0.83 0.17 5.65 25.70 3.03 industries Total 17.73 15.42 13.41 0.82 0.18 2.83 10.95 3.95 Continued

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Continued Estimate of Total Factor Productivity Growth (TFPG) 1994-98 (annual compound growth rates) dV dL dK Vsk Vsl dL.Vsl dK.Vsk 31 Food, beverages and -0.42 1.46 -6.08 0.92 0.08 0.12 -5.59 tobacco 32 Textile, wearing -3.43 -3.56 2.17 0.70 0.30 -1.06 1.52 apparel and leather 33 Wood, wood products -4.91 4.67 -17.37 0.74 0.26 1.20 -12.89 and furniture 34 Paper, printing and -7.79 0.91 6.63 0.56 0.44 0.40 3.73 publishing 35 Chemicals, petroleum, 0.25 3.22 -1.17 0.83 0.17 0.54 -0.98 rubber and plastic 36 Non-metallic mineral -6.10 0.01 -25.73 0.73 0.27 0.00 -18.71 products 37 Basic metal industries -32.94 -10.88 18.47 0.81 0.19 -2.03 15.02 -0.24 -0.02 -0.78 0.78 0.22 -0.00 -0.61 38 Fabricated metal, machinery and equipment 39 Other manufacturing -14.90 -8.97 -7.58 0.76 0.24 -2.18 -5.74 industries Total -2.57 -1.59 -5.18 0.81 0.19 -0.30 -4.20 Notes: TFPG 5.06 -3.89 6.78 -11.92 0.69 12.60 -45.93 0.37 -6.98 1.93

Source:

Estimates of TFPG was based on TFPG = dV Svk.dK Svl.dL. dV: growth of real value added dK: growth of real capital stock dL: growth of labour inputs (number of workers) Svk: Average share of capital payments in value added Svl: Average share of labour payments in value added Wholesale Price Indices (WPI, 1974=100), computed by the CBSL, were used to obtain the real values. Thus, output was deflated by the commodity-wise average WPI (excluding fuel and light), material inputs by WPI on intermediate goods and, capital by WPI on investment goods. CBSL (various issues): Annual Reports DCS (various issues): Annual Survey of Industries

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Appendix 4 Consumption, Savings and Investment 1959-2000 (as % of GDP) Consumption Savings Investment Private Public Domestic National Private Public 1959 71.4 13.7 14.8 13.4 12.5 4.9 1960 74.8 13.6 11.7 10.6 10.1 4.5 1961 71.4 13.5 15.2 14.2 10.3 5.7 1962 71.9 14.0 14.2 13.1 9.7 5.8 1963 72.3 13.7 14.2 13.0 10.5 5.3 1964 73.8 14.0 12.3 11.3 10.0 4.3 1965 72.7 14.3 12.9 12.5 7.5 5.0 1966 75.3 13.9 10.8 10.1 10.1 4.2 1967 73.9 13.7 12.0 11.1 10.3 4.9 1968 74.0 13.1 12.9 12.3 10.9 5.0 1969 74.4 12.6 13.0 12.1 14.9 4.3 1970 72.3 11.9 16.7 15.0 14.5 4.4 1971 72.4 12.6 16.0 14.7 11.8 5.2 1972 71.8 12.4 16.1 14.8 11.9 5.4 1973 76.5 11.0 12.5 11.5 10.2 3.6 1974 80.2 11.5 8.2 7.5 9.5 6.2 1975 82.6 9.3 8.1 7.4 9.9 5.7 1976 76.1 10.0 13.9 13.1 9.7 6.5 1977 73.3 8.6 18.1 17.7 9.3 5.1 1978 75.2 9.5 15.2 15.5 13.7 6.4 1979 77.1 9.2 13.8 14.8 18.7 7.1 1980 80.3 8.5 11.2 14.0 25.2 8.6 1981 80.9 7.4 11.7 14.3 23.1 4.7 1982 79.8 8.3 11.9 15.4 25.8 5.0 1983 78.1 8.1 13.8 16.4 24.0 4.9 1984 72.3 7.8 19.9 22.2 21.3 4.6 1985 77.9 10.2 11.9 14.2 19.0 4.8 1986 77.7 10.3 12.0 14.5 18.3 5.3 1987 77.2 9.9 12.8 15.3 17.7 5.7 1988 78.1 9.8 12.0 14.2 16.9 5.9 1989 77.3 10.5 12.2 14.6 16.0 5.7 1990 75.9 9.8 14.3 16.8 18.3 3.9 1991 77.4 9.8 12.8 15.2 18.6 4.3 1992 75.4 9.6 15.0 17.9 21.1 3.2 1993 74.8 9.2 16.0 20.2 21.4 4.2 1994 75.1 9.7 15.2 19.1 24.0 3.0 1995 73.2 11.5 15.3 19.5 22.2 3.5 1996 74.1 10.5 15.3 19.0 21.2 3.1 1997 72.3 10.4 17.3 21.5 21.0 3.4 1998 71.4 9.8 19.1 23.4 21.9 3.4 1999 71.1 9.0 19.5 23.5 23.8 3.3 2000 72.2 10.5 17.3 21.4 24.8 3.2 Note: Private sector is defined inclusive of public corporations and, public sector inclusive of public enterprises. Source: CBSL (2000)

Total 17.3 14.6 16.0 15.5 15.7 14.3 12.5 14.3 15.2 15.9 19.3 18.9 17.1 17.3 13.7 15.7 15.6 16.2 14.4 20.0 25.8 33.8 27.8 30.8 28.9 25.8 23.8 23.7 23.3 22.8 21.7 22.2 22.9 24.3 25.6 27.0 25.7 24.2 24.4 25.2 27.1 28.0

Sri Lanka

90

Appendix 5 Fiscal Operations 1950-2000 Appendix 5 (a) Revenue, Expenditure and Deficit Financing as % of GDP 1950-2000 Revenue Expenditure Fiscal balance Current Capital Total Current Overall account balancea 1950 16.1 11.9 8.4 20.3 4.2 -4.2 1951 19.7 15.0 5.8 20.8 4.7 -1.1 1952 21.1 19.2 7.9 27.1 1.9 -6.0 1953 21.2 17.5 9.0 26.5 3.7 -5.3 1954 21.6 14.2 7.3 21.5 7.4 0.1 1955 22.1 14.6 5.8 20.4 7.6 1.7 1956 24.7 17.0 9.0 26.0 7.7 -1.3 1957 24.3 18.8 10.2 29.0 5.5 -4.7 1958 23.3 20.3 7.0 27.3 2.9 -4.0 1959 20.7 19.9 7.3 27.2 0.9 -6.4 1960 20.9 20.3 6.8 27.1 0.6 -6.2 1961 22.0 21.4 7.3 28.7 0.6 -6.7 1962 23.3 21.5 8.3 29.8 1.8 -6.5 1963 21.6 20.8 6.1 26.9 0.8 -5.3 1964 22.6 22.5 6.0 28.5 0.1 -5.9 1965 22.5 21.4 6.4 27.8 1.1 -5.3 1966 22.0 21.5 7.3 28.8 0.5 -6.8 1967 21.6 20.1 8.2 28.4 1.5 -6.7 1968 20.1 20.4 6.4 26.8 -0.3 -6.7 1969 21.4 20.4 7.7 28.1 1.0 -6.7 1970 20.0 19.5 7.4 26.9 0.6 -6.9 1971 20.0 21.2 6.5 27.8 -1.2 -7.7 1972 21.5 22.2 6.1 28.3 -0.7 -6.8 1973 21.9 21.0 6.4 27.3 1.0 -5.4 1974 20.1 19.0 5.5 24.5 1.2 -4.4 1975 19.1 19.4 7.6 27.0 -0.3 -7.9

Source of financing Foreignb Domesticc 0.0 0.0 0.2 0.1 1.7 0.7 0.6 0.6 0.6 0.7 0.5 0.3 0.8 1.2 1.2 1.2 1.4 2.3 1.8 3.0 1.7 1.7 1.9 1.0 1.6 2.7 4.2 1.1 5.8 5.2 -1.8 -2.5 0.7 4.2 3.4 5.7 5.7 6.4 5.8 4.1 4.7 4.1 5.4 4.4 4.9 3.7 5.2 6.0 4.9 4.4 2.8 5.2 Continued

Sri Lanka

91

Continued Revenue Current Expenditure Capital Total Fiscal balance Current Overall account balancea 0.6 -9.6 1.5 -5.8 3.0 -14.1 2.2 -13.8 1.1 -23.1 0.1 -15.6 -2.1 -17.4 1.1 -13.4 6.1 -9.0 2.2 -11.7 1.8 -12.2 1.3 -11.1 -2.0 -15.7 -1.2 -11.2 -1.2 -9.9 -2.0 -11.9 -0.9 -8.0 -0.8 -8.7 -2.9 -10.5 -2.7 -10.1 -3.8 -9.4 -2.2 -7.9 -2.4 -9.2 -1.0 -7.5 -3.4 -9.9 Source of financing Foreignb Domesticc

1976 19.0 18.4 10.3 28.6 3.2 6.5 1977 18.4 16.9 7.3 24.2 3.4 2.4 1978 27.4 24.4 17.1 41.5 9.3 4.8 1979 22.8 20.7 16.0 36.6 7.1 6.7 1980 19.6 18.5 24.2 42.7 9.2 13.9 1981 17.4 17.2 15.7 33.0 8.9 6.6 1982 16.3 18.5 15.3 33.8 8.2 9.3 1983 19.2 18.1 14.5 32.6 8.1 5.3 1984 22.2 16.0 15.1 31.1 6.4 2.6 1985 22.3 20.1 13.9 34.0 6.4 5.3 1986 20.7 18.9 14.1 33.0 7.1 5.1 1987 21.4 20.1 12.4 32.5 5.3 5.8 1988 18.8 20.8 13.7 34.5 6.2 9.5 1989 21.4 22.6 10.0 32.6 4.9 6.3 1990 21.1 22.3 8.7 31.0 5.7 4.2 1991 20.5 22.5 9.8 32.3 7.3 4.3 1992 20.2 21.1 7.1 28.2 3.7 3.7 1993 19.7 20.5 7.9 28.4 3.6 4.9 1994 19.0 21.9 7.5 29.5 3.5 6.5 1995 20.4 23.1 7.4 30.5 4.5 5.1 1996 19.0 22.8 5.7 28.5 2.3 6.5 1997 18.5 20.8 5.7 26.4 1.9 3.4 1998 17.3 19.7 6.8 26.5 1.7 7.0 1999 17.6 18.7 6.5 25.1 0.7 6.7 2000 16.8 20.3 6.5 26.7 0.4 9.4 a: Overall balance before grants. b: Foreign sources include both loans and grants. c: Domestic sources do not include privatization proceeds, which was a source of financing budget deficit after 1991. Source: CBSL (2000)

Sri Lanka

92

Appendix 5 (b) Government Debt as % of GDP 1950-2000 Year Domestic Foreign Total 1950 13.7 3.2 16.9 1951 13.6 2.7 16.3 1952 18.9 4.3 23.2 1953 23.2 4.6 27.8 1954 20.1 4.4 24.5 1955 17.0 4.4 21.4 1956 18.6 5.1 23.7 1957 21.8 5.3 27.1 1958 22.5 5.3 27.9 1959 24.3 4.8 29.1 1960 28.9 5.1 34.0 1961 34.1 5.9 40.0 1962 38.7 5.9 44.6 1963 41.1 6.0 47.7 1964 43.3 7.0 50.4 1965 45.7 9.1 54.9 1966 50.3 12.9 63.2 1967 50.7 15.2 65.9 1968 48.5 14.7 63.2 1969 47.1 15.4 62.5 1970 46.1 17.5 63.6 1971 49.7 19.9 69.6 1972 52.0 19.3 71.2 1973 46.6 20.1 66.8 1974 39.7 12.0 51.8 1975 40.9 13.9 54.8 Source: CBSL (2000)

Year 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Domestic 42.0 39.5 38.4 37.5 43.7 41.8 45.6 42.6 33.6 38.6 38.7 40.2 44.4 46.7 41.6 40.9 40.0 42.8 43.0 43.3 46.4 43.5 45.5 49.1 53.9

Foreign 16.4 29.1 34.2 30.2 33.5 34.3 35.5 38.4 34.9 41.7 48.0 56.8 56.6 62.0 55.0 57.6 55.4 54.1 52.1 51.9 46.8 42.3 45.3 45.9 43.2

Total 58.5 68.6 72.5 67.7 77.2 76.1 81.2 81.0 68.5 80.2 86.8 97.0 101.0 108.7 96.6 98.5 95.4 96.9 95.1 95.2 93.3 85.8 90.8 95.1 97.1

Sri Lanka

93

Appendix 6 International Trade 1950-2000 Appendix 6 (a) Composition of Exports and Imports 1950-2000 Exports as % of total Imports as % of total Agricultural Industrial Other Consumer Intermediate Investment exportsa exportsb exports goods goods goods 1950 93.7 6.3 51.0 10.1 38.9 1951 89.4 10.6 56.6 17.5 25.7 1952 88.4 11.6 50.6 17.0 32.3 1953 89.7 10.3 58.0 16.5 25.3 1954 89.6 10.4 56.4 17.6 25.9 1955 91.2 8.8 51.7 16.4 31.9 1956 89.3 10.7 52.7 14.2 33.0 1957 87.9 12.1 48.9 19.3 31.8 1958 90.8 9.2 51.0 14.2 34.9 1959 90.5 9.5 60.0 19.8 19.4 1960 90.5 9.5 61.0 20.3 18.1 1961 91.0 9.0 57.1 22.5 19.9 1962 92.1 7.9 54.6 24.6 20.3 1963 92.1 7.9 52.4 25.0 21.7 1964 92.8 7.2 63.9 20.1 15.4 1965 93.8 6.2 52.8 28.1 17.7 1966 94.3 5.7 57.2 23.2 17.8 1967 91.8 8.2 53.6 25.4 19.0 1968 92.4 7.6 52.6 28.9 17.6 1969 92.8 7.2 47.9 23.3 27.5 1970 91.7 8.3 55.4 20.0 23.6 1971 91.5 8.5 56.0 20.7 21.1 1972 87.1 2.8 10.0 51.8 24.3 21.2 1973 80.1 8.3 11.6 52.4 30.0 16.6 1974 76.2 13.9 9.9 46.8 42.1 9.9 1975 78.7 13.2 8.1 50.5 36.0 12.4

As % of GDP Exports Imports 40.4 30.1 41.3 33.8 33.3 37.7 34.9 35.8 38.1 29.4 37.1 27.9 34.1 32.0 32.4 34.7 31.1 31.2 27.3 31.3 27.3 29.2 25.2 24.8 25.9 23.8 23.4 20.2 24.1 25.3 24.1 18.2 20.4 24.3 18.7 19.2 19.0 20.3 16.4 21.7 14.9 16.9 13.9 14.1 13.2 13.5 14.2 14.8 14.6 19.2 14.8 19.8 Continued

Sri Lanka

94

Continued Exports as % of total Imports as % of total As % of GDP Agricultural Industrial Other Consumer Intermediate Investment Exports Imports exportsa exportsb exports goods goods goods 1976 74.3 15.3 10.4 36.4 48.6 13.8 15.9 15.4 1977 79.3 14.2 6.5 42.2 44.1 12.4 18.2 16.5 1978 78.9 14.7 6.4 38.3 38.1 22.9 31.0 34.4 1979 70.7 24.5 4.9 34.7 40.5 24.2 29.2 43.0 1980 61.8 33.0 5.2 29.9 45.7 24.0 26.4 51.0 1981 57.8 35.4 6.7 25.2 52.7 21.7 24.8 43.0 1982 54.3 38.6 7.1 20.5 51.6 27.6 21.6 42.3 1983 58.0 35.1 6.9 25.5 47.7 26.5 20.6 37.5 1984 60.4 34.6 5.0 23.2 50.0 25.6 24.3 30.9 1985 52.5 39.5 8.0 19.4 54.3 19.2 22.3 33.3 1986 46.3 46.6 7.1 22.5 52.5 19.3 19.0 30.4 1987 42.4 48.6 9.0 22.8 57.2 18.7 20.9 30.8 1988 42.8 48.3 8.8 24.6 56.8 17.0 21.1 32.0 1989 39.3 50.7 10.1 26.1 56.4 15.0 22.3 31.8 1990 36.3 52.2 11.4 26.4 51.8 21.7 24.7 33.5 1991 32.3 61.7 6.0 25.5 50.7 23.5 22.1 34.0 1992 24.6 71.7 3.8 21.0 53.8 24.3 25.4 36.1 1993 22.9 73.4 3.7 19.3 5.7 26.1 27.7 38.7 1994 21.9 74.8 3.4 19.5 50.9 28.7 27.4 40.7 1995 21.8 75.4 2.8 18.5 54.6 22.4 29.2 40.8 1996 23.5 73.4 3.1 19.0 54.6 22.1 29.5 39.2 1997 22.9 74.1 3.0 18.5 55.2 22.6 30.8 38.9 1998 22.6 75.2 2.2 19.2 52.8 25.1 30.6 37.5 1999 20.5 77.0 2.5 18.9 5.0 26.2 29.3 38.0 2000 18.2 77.6 4.2 17.3 53.5 23.6 33.5 44.1 a: Until 1963, Agricultural exports include tea, rubber and coconut only as minor agricultural exports have been categorized under other exports. b: Until 1971, industrial exports that were not reported separately have been categorized under other exports. Source: CBSL (2000)

Sri Lanka

95

Appendix 6 (b) Trade Indices 1950-2000 (1990 = 100) Prices Volume Year Exports Imports Exports Imports 1950 5.6 1.1 48.1 34.8 1951 6.9 1.5 48.7 39.2 1952 5.3 1.5 49.3 39.2 1953 5.3 1.5 50.5 39.8 1954 5.9 1.3 52.4 37.0 1955 6.3 1.2 55.4 41.5 1956 5.9 1.2 51.8 46.5 1957 5.6 1.3 50.5 49.3 1958 5.6 1.2 53.6 49.9 1959 5.6 1.2 52.4 57.8 1960 5.6 1.2 56.0 56.6 1961 5.3 1.2 57.8 45.4 1962 5.3 1.2 62.1 46.0 1963 5.3 1.3 59.7 39.2 1964 5.3 1.6 65.2 48.2 1965 5.3 1.5 67.6 36.4 1966 4.9 1.5 61.5 49.9 1967 4.6 1.5 63.9 42.6 1968 5.6 1.9 65.8 43.2 1969 5.6 2.0 62.7 46.0 1970 5.6 2.2 65.2 43.2 1971 5.6 2.3 63.3 38.1 1972 5.6 2.4 62.1 37.6 1973 6.6 3.2 62.7 33.6 1974 10.2 5.7 54.2 23.5 1975 9.6 6.6 65.2 29.2

Value Exports Imports 3.0 1.8 3.6 2.2 3.8 2.4 3.0 2.2 3.4 1.9 3.8 1.9 3.2 2.2 3.2 2.5 3.2 2.4 3.4 2.7 3.6 2.5 3.2 2.1 3.6 2.1 3.4 1.9 3.6 2.4 3.8 1.8 3.4 2.4 3.2 2.1 4.0 2.7 3.8 2.8 3.8 2.7 3.8 2.4 3.6 2.4 4.8 2.7 5.0 4.2 6.4 5.0

Terms of trade Index Change (%) 519.9 467.1 -10.2 355.9 -23.8 355.9 0.0 440.4 23.7 516.5 17.3 489.3 -5.3 415.9 -15.0 462.1 11.1 462.1 0.0 462.1 0.0 434.9 -5.9 434.9 0.0 391.4 -10.0 326.2 -16.7 355.9 9.1 333.6 -6.3 311.4 -6.7 397.1 27.5 277.3 -30.2 259.9 -6.3 244.7 -5.8 231.1 -5.6 203.9 -11.8 180.6 -11.4 144.8 -19.8 Continued

Sri Lanka

96

Continued Prices Year Exports Imports 1976 11.2 5.9 1977 18.1 7.3 1978 33.0 13.5 1979 36.0 20.5 1980 41.6 29.3 1981 42.6 38.0 1982 41.7 39.5 1983 53.2 41.4 1984 68.1 43.3 1985 60.4 46.8 1986 53.6 43.3 1987 62.1 49.0 1988 76.2 67.0 1989 91.7 80.2 1990 100.0 100.0 1991 105.0 103.9 1992 131.8 108.8 1993 144.7 114.6 1994 151.7 121.0 1995 174.2 140.2 1996 194.9 153.2 1997 213.0 163.7 1998 246.2 189.9 1999 243.3 171.1 2000 265.8 199.1 Source: CBSL (2000) Volume Exports Imports 62.1 32.0 57.2 40.9 60.9 56.1 61.5 69.0 60.3 78.5 62.1 81.3 65.2 81.3 61.5 89.4 72.0 92.7 74.5 88.6 79.5 100.8 80.7 103.3 77.4 98.4 77.1 92.9 100.0 100.0 101.1 113.2 105.1 131.0 120.2 153.4 131.5 172.1 140.9 176.7 146.4 181.4 161.9 203.8 159.5 221.1 168.0 216.6 198.7 244.7 Value Exports Imports 7.2 3.6 10.2 4.6 20.0 14.8 21.8 20.8 23.8 30.4 26.5 30.9 27.0 32.1 32.8 36.7 48.7 40.1 45.0 41.4 42.9 43.8 50.3 50.6 59.0 65.9 70.7 74.5 100.0 100.0 106.2 117.6 138.5 142.5 173.8 175.8 199.5 208.2 245.5 247.8 285.4 277.9 245.1 319.4 390.6 251.0 408.6 271.1 527.8 487.5 Terms of trade Index Change (%) 189.0 30.5 249.2 31.9 244.7 -1.8 175.4 -28.3 142.1 -19.0 111.9 -21.3 105.5 -5.7 128.3 21.6 157.1 22.4 129.2 -17.8 123.7 -4.3 126.7 2.4 113.7 -10.3 114.3 0.5 100.0 -12.5 101.1 1.1 121.1 19.8 126.3 4.3 125.4 -0.7 124.3 -0.9 127.2 2.3 130.1 2.3 131.7 1.2 142.2 8.0 133.5 -6.1

Sri Lanka

97

Appendix 7 International Finance 1950-2000 Appendix 7 (a) Balance of Payments 1950-2000 (US$ million) Current account Exports 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 296.5 387.0 309.3 314.4 362.0 397.5 372.1 350.5 341.0 372.3 377.2 358.5 370.2 358.7 371.1 400.9 351.5 339.4 332.0 320.7 338.7 325.4 317.9 366.4 511.2 563.4 Imports 246.3 317.9 352.0 342.9 290.6 310.4 331.0 370.4 359.7 411.2 421.3 367.7 400.3 392.5 411.6 403.6 423.8 408.4 395.8 446.1 391.8 373.7 360.6 412.9 701.1 767.3 Trade balance 50.2 69.0 -42.6 -28.6 71.4 87.1 41.2 -19.9 -18.7 -38.8 -44.1 -18.3 -30.0 -33.8 -40.5 -2.7 -72.2 -68.9 -63.8 -125.3 -53.1 -48.4 -42.7 -46.5 -189.9 -204.0 Service & income (net) -6.9 -34.2 -29.2 4.8 1.9 -6.5 -12.4 -12.8 -8.6 -2.3 -6.7 -3.8 -0.6 -4.4 -1.5 6.5 3.6 5.1 1.7 -15.1 -17.5 -2.4 -2.5 8.1 11.4 12.7 Private transfers (net) -14.5 -16.2 -21.8 -12.4 -14.1 -16.4 -17.4 -13.9 -16.4 -11.8 -6.5 -6.3 -6.3 -6.3 -7.6 -5.0 -5.5 -4.9 -2.2 -1.2 -0.8 -3.4 -4.4 0.3 -0.3 2.7 Official transfers (net) 2.9 5.0 3.6 5.9 5.7 11.5 9.2 11.1 8.6 7.9 9.2 16.0 13.4 13.2 9.5 4.7 7.7 12.6 17.7 16.8 13.0 42.4 77.2 Current account balance 28.8 18.7 -93.6 -33.2 64.3 67.8 17.2 -40.9 -32.1 -43.7 -46.2 -19.7 -29.1 -35.3 -33.6 12.2 -60.9 -59.2 -59.6 -133.9 -58.8 -36.4 -32.8 -25.1 -136.4 -111.4 Continued

Sri Lanka

98

Continued Exports 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 558.8 767.1 845.1 981.4 1064.7 1065.5 1013.7 1064.1 1462.3 1315.3 1209.7 1395.7 1477.2 1547.1 1983.9 2039.5 2460.8 2863.7 3208.6 3806.6 4095.1 4639.0 4797.8 4610.1 5522.3 Imports 643.1 726.2 1025.4 1449.4 2051.2 1876.9 1994.1 1921.3 1928.1 2044.3 1973.2 2075.1 2240.2 2226.5 2686.4 3036.6 3505.4 4011.3 4767.3 5311.1 5438.8 5863.8 5889.5 5979.3 7319.8 Trade balance -84.3 40.9 -180.3 -468.0 -986.6 -811.4 -980.3 -857.2 -465.8 -729.0 -763.5 -679.4 -763.0 -679.4 -702.5 -997.1 -1044.6 -1147.6 -1558.7 -1504.5 -1343.7 -1224.8 -1091.7 -1369.2 -1797.5 Service & income (net) 13.3 34.3 7.6 47.5 52.0 4.3 -15.1 -60.0 -68.2 -134.3 -129.1 -156.9 -53.2 -157.7 -97.9 -91.2 -32.6 39.4 17.8 -18.0 -92.3 -0.4 -34.9 -106.6 -266.0 Private transfers (net) 6.7 13.7 21.9 48.4 136.7 202.8 265.0 273.7 276.8 266.0 283.9 312.5 319.9 330.7 361.7 398.2 458.7 556.5 622.1 675.2 710.0 787.8 848.2 887.0 974.0 Official transfers (net) 58.5 55.2 57.7 143.8 138.0 162.0 162.4 170.7 202.6 177.7 182.5 180.4 207.0 188.0 61.7 70.7 63.9 56.2 58.5 60.8 49.1 44.5 62.5 25.8 24.5 Current account balance -5.8 144.1 -93.1 -228.4 -660.0 -442.3 -568.1 -472.8 -54.7 -419.5 -426.1 -343.4 -389.3 -318.3 -377.0 -619.4 -554.6 -495.5 -860.3 -786.5 -676.9 -392.9 -225.9 -563.0 -1065.0 Continued

Sri Lanka

99

Continued Capital and financial account Capital Direct account investment (net) (net) 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 -0.4 -10.2 -1.0 -1.5 -2.7 -5.2 -5.2 -8.0 -2.5 -1.9 0.6 -1.3 -0.4 1.0 -0.2 0.0 -2.9 -1.0 -2 -1.8 -0.3 0.3 0.3 0.5 1.4 -0.1

Other Government Short-term private long-term (net) long-term (net) (net) -5.0 0.8 -3.3 4.9 -2.5 8.8 -2.9 -0.2 -3.6 -1.5 14.7 -6.1 -5.2 1.7 -1.5 -5.0 1.9 6.1 -0.6 4.8 0.6 -0.6 4.4 2.3 0.6 12.0 2.1 -0.2 1.5 -1.5 -0.4 5.2 2.9 0.0 9.2 -0.2 0.0 16.6 -0.8 0.4 8.8 -1.9 -0.6 13.2 -3.8 -0.4 22.9 -3.8 -0.4 35.8 1.6 0.2 37.0 -1.2 0.2 78.5 -1.7 0.0 57.6 -0.7 0.0 74.0 -3.9 -0.2 48.6 -6.4 -0.3 68.9 -1.7 0.2 84.6 -2.3 0.0 62.7 -4.3

Capital & financial account balance -4.6 -8.6 5.3 -8.2 4.4 -10.3 -2.3 -3.1 3.6 12.8 0.4 6.5 8.6 16.8 7.1 8.8 15.7 36.0 33.9 75.1 56.6 70.4 42.4 67.3 83.6 58.2

Overall balance 35.0 19.6 -79.3 -44.6 66.8 58.5 10.9 -46.2 -32.7 -29.8 -40.3 -16.5 -14.2 -16.8 -26.6 19.7 -49.0 87.9 -29.4 -53.2 -7.0 32.9 69.5 45.9 -57.0 10.4 Continued

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100

Continued Capital account (net) 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 117.5 1991 134.6 1992 121.6 1993 108.6 1994 113.1 1995 117.3 1996 95.9 1997 87.1 1998 79.6 1999 80.3 2000 51.5 Source: CBSL (2000) Direct investment (net) 0.0 -1.0 1.5 47.0 42.0 50.2 63.6 37.5 32.6 24.4 28.2 58.2 43.0 17.9 41.6 62.7 121.1 187.2 158.2 53.1 119.9 429.8 193.0 176.9 176.0 Other Government Short-term private long-term (net) long-term (net) (net) -5.7 83.1 -7.1 -3.3 51.1 -10.0 0.5 157.2 7.3 9.1 156.2 0.1 40.3 157.5 157.5 52.9 266.0 31.4 194.5 261.2 7.1 94.9 281.0 37.6 -4.7 341.7 -25.5 31.2 273.0 4.4 18.3 291.7 -13.5 -13.0 198.0 39.0 -43.0 245.0 16.0 -50.0 217.0 92.0 -44.6 405.3 -5.7 -24.4 500.2 184.6 25.4 266.2 130.1 187.9 264.8 359.7 294.5 252.8 124.3 90.7 358.3 79.2 1.6 259.2 -17.6 47.4 238.6 -200.7 1.7 203.1 -64.0 196.0 62.1 -142.4 81.6 170.6 88.5 Capital & financial account balance 70.3 36.7 166.5 212.3 398.3 400.6 526.4 451.0 344.1 333.0 324.8 282.2 261.0 276.9 514.1 857.7 664.4 1108.2 942.9 698.6 459.0 602.2 413.4 372.9 568.0 Overall balance 118.3 360.9 120.1 51.9 -191.9 19.9 -48.0 18.0 269.3 -49.3 -70.3 -67.3 -90.7 -88.0 118.7 290.2 189.6 660.9 239.7 51.5 -67.8 162.9 36.8 -263.2 -516.3

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Appendix 7 (b) Balance of Payments 1950-2000 (as % of GDP) Trade balance Current account balance 1950 6.1 3.5 1951 7.0 1.9 1952 -4.5 -9.9 1953 -3.0 -3.5 1954 7.1 6.4 1955 8.0 6.2 1956 3.8 1.6 1957 -1.8 -3.8 1958 -1.6 -2.8 1959 -2.8 -3.2 1960 -3.2 -3.3 1961 -1.3 -1.4 1962 -2.1 -2.0 1963 -2.2 -2.3 1964 -2.5 -2.1 1965 -0.2 0.7 1966 -4.1 -3.5 1967 -3.7 -3.2 1968 -3.6 -3.4 1969 -6.6 -7.0 1970 -2.3 -2.6 1971 -2.0 -1.5 1972 -1.7 -1.3 1973 -1.7 -0.9 1974 -5.3 -3.8 1975 -5.3 -2.9

Capital account balance -0.6 -0.9 0.6 -0.9 0.4 -0.9 -0.2 -0.3 0.3 0.9 0.0 0.5 0.6 1.1 0.4 0.5 0.9 1.9 1.9 3.9 2.5 2.9 1.7 2.4 2.3 1.5

Overall balance 4.3 2.0 -8.4 -4.7 6.7 5.3 1.0 -4.2 -2.8 -2.2 -2.9 -1.1 -1.0 -1.1 -1.6 1.2 -2.8 4.7 -1.7 -2.8 -0.3 1.4 2.7 1.6 -1.6 0.3 Continued

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Continued Trade balance 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: CBSL (2000) -2.9 1.0 -6.6 -13.9 -24.5 -18.3 -20.5 -16.5 -7.7 -12.2 -12.0 -10.1 -11.0 -9.8 -8.8 -11.1 -10.7 -11.1 -13.2 -11.5 -9.7 -8.1 -6.8 -8.8 -10.8 Current account balance -0.2 3.5 -3.4 -6.8 -16.4 -10.0 -11.9 -9.1 -0.9 -7.0 -6.7 -5.1 -5.6 -4.6 -4.7 -6.9 -5.7 -4.8 -7.3 -6.0 -4.9 -2.6 -1.4 -3.6 -6.4 Capital account balance 2.4 0.9 6.1 6.3 9.9 9.1 11.0 8.7 5.7 5.6 5.1 4.2 3.8 4.0 6.4 9.6 6.8 10.7 8.0 5.3 3.3 4.0 2.6 2.4 3.4 Overall balance 3.3 8.8 4.4 1.5 -4.8 0.5 -1.0 0.3 4.5 -0.8 -1.1 -1.0 -1.3 -1.3 1.5 3.2 2.0 6.4 2.0 0.4 -0.5 1.1 0.2 -1.7 -3.1

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Appendix 7 (c) External Assets and External Debt 1950-2000 External assets US$ Months of % of GDP millions imports 1950 237.6 11.6 28.9 1951 254.4 9.6 25.8 1952 184.0 6.3 19.5 1953 134.8 4.7 14.2 1954 197.4 8.2 19.6 1955 258.2 10.0 23.6 1956 266.4 9.7 24.8 1957 223.2 7.2 20.7 1958 196.5 6.6 17.1 1959 154.3 4.5 11.3 1960 114.0 3.2 8.1 1961 111.7 3.6 7.9 1962 106.0 3.2 7.3 1963 97.1 3.0 6.3 1964 73.5 2.1 4.6 1965 92.1 2.7 5.3 1966 66.5 1.9 3.8 1967 75.7 2.2 4.1 1968 78.1 2.4 4.5 1969 63.3 1.7 3.3 1970 67.6 2.1 3.0 1971 83.6 2.7 3.4 1972 108.5 3.6 4.3 1973 126.1 3.7 4.5 1974 132.8 2.3 3.7 1975 108.1 1.7 2.8

US$ millions 26.3 26.2 26.4 26.4 40.2 43.1 44.2 48.7 54.3 58.3 61.8 64.5 72.6 85.5 86.3 102.5 114.9 124.7 181.2 230.9 419.2 465.9 485.1 552.0 648.9 729.3

External debt Debt servicea 3.1 2.6 2.0 1.4 1.8 2.0 1.1 0.9 0.8 1.0 0.9 1.1 1.5 4.7 3.3 5.5 4.3 9.3 15.9 20.1 21.9 21.8 23.0 17.8 23.0

% of GDP 3.2 2.7 2.8 2.8 4.0 3.9 4.1 4.5 4.7 4.3 4.4 4.6 5.0 5.6 5.4 5.9 6.6 6.7 10.3 12.1 18.5 19.2 19.2 19.8 18.1 19.0 Continued

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Continued External assets External debt US$ Months of % of GDP US$ Debt millions imports millions servicea 1976 158.8 3.0 5.5 773.2 20.1 1977 358.1 5.9 8.7 856.1 16.0 1978 482.2 5.6 17.6 1114.3 15.5 1979 624.9 5.2 18.6 1245.7 13.0 1980 375.9 2.2 9.3 1666.8 12.4 1981 448.8 2.9 10.1 2060.4 16.8 1982 526.9 3.2 11.0 2500.0 18.6 1983 521.0 3.3 10.0 2651.7 21.6 1984 720.8 4.5 11.9 2983.8 17.5 1985 672.0 3.9 11.2 3440.7 21.0 1986 606.9 3.7 9.5 4082.4 26.2 1987 600.7 3.5 8.9 4770.6 27.5 1988 576.0 3.1 8.3 4908.9 28.6 1989 584.6 3.2 8.4 5146.0 24.2 1990 856.7 3.8 10.7 5783.1 17.8 1991 1156.0 4.6 12.9 6489.4 18.5 1992 1439.9 4.9 14.8 6831.7 17.1 1993 2123.8 6.4 20.6 7602.0 13.8 1994 2874.4 7.2 24.4 8298.0 13.7 1995 2901.9 6.6 22.1 8694.0 16.5 1996 2717.0 6.0 19.7 8486.0 15.3 1997 3131.8 6.4 20.7 8197.0 13.3 1998 2907.2 5.9 18.0 8749.0 13.3 1999 2581.7 5.2 16.5 9088.0 15.2 2000 2125.6 3.5 12.8 8859.0 14.7 a: Ratio, as a percentage of earnings from merchandise exports and services Source: CBSL (2000) % of GDP 26.7 20.8 40.7 37.1 41.4 46.6 52.4 51.0 49.1 57.4 64.2 70.9 70.6 74.4 72.1 72.3 70.2 73.6 70.4 66.3 61.4 54.2 54.2 58.1 53.2

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Appendix 8 Nominal and Real Exchange Rates 1960-2000 (1960 = 100) Exchange rate (SLRs/US$) Consumer prices (% change) Nominal % Change Real % Change Sri Lanka USA 1960 4.75 4.75 1961 4.76 -0.2 4.73 0.3 1.6 1.1 1962 4.76 0.0 4.74 -0.0 1.1 1.1 1963 4.76 0.0 4.68 1.2 2.6 1.4 1964 4.78 -0.4 4.61 1.6 3.1 1.1 1965 4.78 0.0 4.69 -1.7 0.0 1.7 1966 4.78 0.0 4.83 -3.0 0.0 3.1 1967 5.93 -19.4 6.00 -19.5 2.5 2.6 1968 5.93 0.0 5.93 1.1 5.4 4.2 1969 5.96 -0.5 5.84 1.7 7.9 5.6 1970 5.96 0.0 5.85 -0.3 5.6 5.9 1971 5.96 0.0 5.93 -1.3 2.8 4.2 1972 6.70 -11.0 6.48 -8.6 6.3 3.5 1973 6.75 -0.7 6.32 2.5 9.7 6.2 1974 6.69 0.9 6.19 2.1 12.2 10.9 1975 7.71 -13.2 7.31 -15.2 6.6 9.2 1976 8.83 -12.7 8.73 -16.3 1.4 5.8 1977 15.56 -43.3 16.19 -46.1 1.1 6.4 1978 15.51 0.3 15.49 4.5 12.2 7.6 1979 15.45 0.4 15.51 -0.1 10.8 11.4 1980 18.00 -14.2 16.27 -4.7 26.0 13.5 1981 20.55 -12.4 17.37 -6.3 18.0 10.3 1982 21.32 -3.6 17.27 0.6 10.8 6.2 1983 25.00 -14.7 18.33 -5.8 14.0 3.2 1984 26.28 -4.9 17.24 6.3 16.6 4.3 1985 27.41 -4.1 18.34 -6.0 1.5 3.5 1986 28.52 -3.9 17.98 2.0 8.1 1.8 1987 30.76 -7.3 18.67 -3.7 7.7 3.7 1988 33.03 -6.9 18.29 2.1 14.1 4.0 1989 40.00 -17.4 20.82 -12.2 11.5 4.9 1990 40.24 -0.6 18.17 14.6 21.5 5.4 1991 42.58 -5.5 17.85 1.8 12.2 4.2 1992 46.00 -7.4 17.84 0.1 11.4 3.1 1993 49.56 -7.2 17.73 0.7 11.7 3.0 1994 49.98 -0.8 16.90 4.9 8.5 2.5 1995 54.05 -7.5 17.45 -3.2 7.6 2.8 1996 56.71 -4.7 16.26 7.4 15.9 2.9 1997 61.29 -7.5 16.41 -0.9 9.6 2.3 1998 67.78 -9.6 16.86 -2.7 9.4 1.6 1999 72.12 -6.0 17.50 -3.7 4.7 2.1 2000 80.06 -9.9 18.92 -7.5 6.2 3.4 Note: Estimate of the Real Exchange Rate (RER) is based on RER = NER (PUS/PSL), using the year-end Nominal Exchange Rate (NER) and the Consumer Price Index of USA (PUS) and that of Sri Lanka (PSL). Source: CBSL (2000) for exchange rates; IMF (various issues) for consumer prices

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