Development economists and Agencies have considered infrastructure and human resource development to be at the centre of the development process. Infrastructure refers, in this note, to physical structures, such as roads, electricity, irrigation, water and sanitation and telecommunication. These infrastructure facilities not only support the production of goods and services in an economy but they also facilitate day-to-day living of the populace. Infrastructure, therefore, constitutes an important part of the capital stock that is a crucial determinant of any country’s development prospects through the provision of essential public goods and services.

Sri Lanka has recently mobilized very substantial loans from China to fund large infrastructure projects (e.g. the Norochcholai power station and the Hambantota port). It would, therefore, be useful to understand better the manner in which the Chinese authorities administer their foreign loan programs.

Sri Lanka, which was a low-income country (per capita income below $2,000) until a few years ago, has now reached lower-middle-income country status ($2,840). Of course, while Sri Lanka can be proud of this achievement, middle-income country status requires it to operate within a new paradigm. In the 80’s and to a lesser extent in the 90’s Sri Lanka was the ‘Darling’ of donor agencies who were generous in providing concessionary financing to poor countries which had liberal economies and polities. However, as a lower-middle-income country Sri Lanka is no longer entitled to such finance. The country is now more dependent on international capital markets to finance its development work.

The Central Bank, in its latest Annual Report, has downgraded its growth forecast for 2012 from 8% to 7.2%. This is due to a combination of adverse global developments and the negative effects of domestic policy misalignments. The contractionary measures introduced to address the imbalance in the trade account (ie to encourage the country to live within its means) may well result in growth being less than the 7.2% forecast by the Central Bank. It is important, therefore, that reforms are introduced to accelerate recovery in order to achieve the government’s own growth target of 8% or more. The Pathfinder Foundation (PF) is putting forward some suggestions to begin a discussion/debate on how this can be achieved.

Preamble
State ownership of public utilities dates back to the colonial period. The early post-Independent years saw the state establish public enterprises that were involved in the production and distribution of key goods and services. The share of state ownership in the economy expanded steadily and gathered momentum in the 1970s when government policy, in the name of socialist or progressive reforms, sought to gain control of the “commanding heights of the economy”. State involvement in production and distribution was rolled back to a certain extent, during the period 1977 – 2005, as successive governments privatized a number of state enterprises. The privatization process has been halted since 2005. The state - owned enterprises sector still accounts for a significant share of the economy (see below). Despite improvements in their performance, these enterprises continue to provide a very low or negative return on investment for the people of Sri Lanka.

Avoiding a Crisis
The Pathfinder Foundation (PF) commends the Treasury and Central Bank for the policy measures introduced recently. This has prevented an external payments crisis. Without remedial action, the country would not have been able to meet its debt obligations and/or finance essential imports within a short period of time. There is considerable evidence from around the world that payments crises have a devastating impact on living standards and results in political instability. The poor and vulnerable bear a disproportionate share of the pain. The actions taken are, therefore, necessary and unavoidable. The PF has called for the use of the full range of macroeconomic instruments to tackle the imbalance in the external account. It, therefore, welcomes the measures that have been taken by the authorities. They are courageous and have improved the prospects of stabilizing the economy and securing a more favourable medium-term outlook.

The macroeconomic imbalances
Sri Lanka has achieved a growth rate of 8.3% last year and inflation fell to 4.9% year – on- year in December 2011. These are noteworthy achievements at a time when the global economic landscape has been hostile with a slowdown in the US and a crisis in Europe; key markets for Sri Lanka’s exports and tourism. The Central Bank and the Treasury deserve credit for their role in the attainment of such positive growth and inflation outcomes in the context of a difficult global economic landscape. However, there are balance of payments pressures that have emerged which require an immediate policy response. The Pathfinder Foundation (PF) has issued two Economic Alerts (no’s: 19 & 23) in recent weeks, drawing attention to the unsustainable trends in the country’s external account. In our view, the need for early remedial action is so pressing that the subject merits yet another call for the authorities to initiate decisivemeasures to address the excess demand in the system. The difficult international economic environment will increasingly influence policy formulation in the period ahead. It will necessitate a re-thinking of the current policy stance.

Widening Trade Deficit
Concerns regarding Sri Lanka’s trade deficit have become elevated. It amounted to $6.9 billion in the first nine months of 2011 and is projected to exceed $8 billion by the end of this year. The corresponding figure for 2010 was $5.2 billion. This represents a projected deterioration of 73.1%. This decline has taken place despite a 27.7% increase in exports ($7.8 billion) in the first three quarters of this year. However, this improvement in exports was more than offset by a 51.8% increase in imports ($14.7 billion). The upsurge in imports has been fuelled by an expansion in private sector credit. This makes it important to explore whether this combination of events was an inevitable consequence of interest rates declining at a time when the real effective exchange rate was significantly over-valued (by about 20%).

From War and Destruction to Peace and Reconstruction
Both before and following the end of Sir Lanka’s 30-year separatist war in May 2009, it was recognized that rapid economic recovery in the Northern Province would be the key to lasting reintegration and reconciliation within a united country. Nearing the two and a half year point since the cessation of hostilities, the Pathfinder Foundation (PF) examined the current pace and scope of economic development in the North, with a specific focus on private sector investment. The premise is that rapid economic growth in the North will largely depend on the private sector, in combination with essential government investments in physical and social infrastructure and business environment policies that are tailored to the special needs in the Northern Province.

The Pathfinder Foundation with the assistance of Volunteers for Economic Growth Alliance (VEGA) and USAID, recently commissioned a study to identify the policy and regulatory reforms that are required to make Sri Lanka a leading country in investor friendliness. Improving the business climate is not an end in itself. A better business environment is a means for the achievement of the national objective of rapid economic growth resulting in increase in the living standard of the people and reducing poverty.

India has reduced its sensitive list of products for the Least Developed Countries (LDC’s) under the agreement on the South Asia Free Trade Area (SAFTA) from 480 to 25 tariff lines. This means that Afghanistan, Bhutan, Nepal and most importantly Bangladesh will enjoy a significant competitive advantage over Sri Lankan businesses in accessing the rapidly growing Indian market. (Sri Lanka is ineligible for such preferences as it is a lower middle income country.) Local entrepreneurs have already invested in Bangladesh to take advantage of lower costs and the trade preferences enjoyed by that country as a LDC. Bangladesh’s increased preferential access to the Indian market is likely to increase the momentum of such investment and accelerate the loss of growth, employment and incomes experienced by Sri Lanka.

The Pathfinder Foundation strongly supports the depreciation of the Rupee by three percent announced in the Budget Speech. The Economic Alert – 15 called for early remedial action to address the deteriorating trade balance; the buildup of foreign commercial debt/increased debt servicing; and the decline in non-borrowed reserves and running down of extremely large amounts of the country’s foreign reserves defending the Rupee.