Trade Policy Issues in Asian Development

Prema-chandra Athukorala

• Publisher: Routledge
• Year: 1998
• Print ISBN: 9780415169271
• eBook ISBN: 9781134701223
• Topic: Business
• Subtopic: Business General
• Index: Business

This study examines issues of trade policy in the light of the experience of developing Asian economies. Case studies highlight rapidly unfolding issues in trade and development with reference to Sri Lanka, Malaysia, India, Indonesia, Pakistan, South Korea, Taiwan and Thailand.The issues explored include trade liberalization and industrial adjustme

Part I
TRADE POLICY AND DEVELOP MENT

2
TRADE POLICY REFORMS AND INDUSTRIAL RESTRUCTURING IN SRI LANKA

The debate on trade policy reforms in developing countries is far from settled. While there is a growing consensus in the economic profession that old-style interventionist import-substitution policies have ‘misfired’, there is no agreement on the appropriate way forward. The mainstream policy advocacy in the neo-classical tradition of development economics sees the removal of government in direct production activities and shifting towards market forces as the appropriate strategy for achieving rapid, robust and equitable growth (Little 1982, Bhagwati 1993b, Krueger 1997). The economists of structuralist persuasion are, however, less sanguine about the desirability of such market-oriented reforms (Helleiner 1992 and 1994, Rodrik 1992, Taylor 1988). Based on the widespread failure of market-oriented policy reforms in many developing countries, they argue for activist and selective public policies tailored to the circumstances of each individual country, while eschewing indiscriminate state intervention. Apart from stressing the potential adverse effects in the short run if weak domestic industry is exposed to foreign competition, the structuralists draw upon the conventional economic arguments for selective intervention on grounds of learning by doing and dynamic economies of scale achievable in the context of a protected domestic market. The mainstream economists counter the structuralist critique by arguing that reforms failed in many developing countries not because of an inherent deficiency of the market paradigm but because of the partial and half-hearted nature of reform process.

This chapter aims to contribute to this debate through a case study of Sri Lanka. Sri Lanka has experienced a series of changes in its trade regime since attaining independence from British colonial rule in 1948. During the first decade after independence it continued with a liberal trade regime, until growing balance of payments problems induced a policy shift towards protectionist import substitution policies. By the mid-1970s the Sri Lankan economy had become one of the most inward-oriented and regulated outside the group of centrally planned economies, characterised by stringent trade and exchange controls and pervasive state interventions in all areas of economic activity. In 1977, Sri Lanka responded to the dismal economic outcome of this policy stance by a sharp change in policy direction and embarked on an extensive economic liberalisation process, becoming the first country in the South Asian region to do so. Despite major macroeconomic problems, political turmoil and government changes, market-oriented reforms have been sustained and broadened over almost two decades so that Sri Lanka today stands out as one of the most open economies in the developing world. This basic policy orientation looks set to continue in the foreseeable future. Indeed, the most dramatic change in the Sri Lankan political landscape in recent years has been the convergence in broad economic policies among the major political parties and groupings; achieving greater openness and liberalisation is now a bipartisan policy in Sri Lanka. Given the decisive policy shift in 1977 and policy continuity during the ensuing years, Sri Lanka appears to provide a valuable laboratory for the study of the impact of foreign trade policy regimes in a developing economy.

The typical pre-liberalisation developing economy is one in which a variety of sectors and markets, as well as the foreign trade regime, are subject to controls. In addition to incurring significant economic costs individually, these controls interact with one another to magnify their total cost to the economy. The manner in which the economy reacts to trade liberalisation depends on what happens in related markets. Moreover, macroeconomic influences provide the framework within which firm-level decisions are made, and thus affect importantly the outcome of liberalisation reforms. We attempt to examine the Sri Lankan experience by taking various liberalisation initiatives as a package and paying attention to the macroeconomic setting in determining the liberalisation outcome. A major limitation of most of the available studies on industrial adjustment under liberalisation reforms have placed overwhelming emphasis on the trade liberalisation component of reforms while paying little attention to the interaction among different markets and/or the role of the macroeconomic regime.¹

The structure of the chapter is as follows. In the next section we trace the evolution of trade and industry policy in Sri Lanka since independence, followed by a discussion of the key elements of the market-oriented reforms initiated in 1977. Then we examine the industrialisation experience since 1977 in historical context, placing emphasis on aspects such as patterns of industrial growth, export orientation and factor productivity growth. This is followed by an in-depth analysis of the response of foreign investors to the significant trade-cum-investment liberalisation reforms and the pivotal role played by export-oriented foreign direct investment (EOFDI) in transforming a classical primary commodity-dependent economy into a ‘new exporting country’ (NEC). The final section summarises the main findings and draws policy inferences. A key theme running through the chapter is the importance of the concomitant liberalisation of both trade and investment policy regimes in determining the outcome of liberalisation reforms in small trade-dependent countries like Sri Lanka. We also draw attention to the need for supportive macroeconomic policies if trade liberalisation were to achieve its full growth impact.

Policy context

Policy trends since independence

During the first decade after independence in 1948, Sri Lanka continued as an open trading nation with only relatively minor trade or exchange rate restrictions and liberal domestic policies. From the late 1950s, a combination of change in political leadership and balance of payments difficulties led to the adoption of a state-led import substitution industrialisation strategy. Trade restrictions, which were introduced in the late 1950s to keep the negative trade balance under control, soon turned out to be the key instrument in the hands of the national planners in directing private sector activities in line with (perceived) national priorities. Following a hesitant and mild liberalisation attempt during 1968–70, the period from 1970 to 1977 was marked by further direct government intervention in the economy under the guise of creating a ‘socialist society’. By the mid-1970s, these policy shifts had transformed the Sri Lankan economy into one of the most highly regulated, inward oriented, statist economies outside the communist block (Fitter 1973, Rajapatirana 1988, Cuthbertson and Athukorala 1990).

The policy makers in Sri Lanka, like their counterparts in other developing countries, expected the growth of IS industries to reduce the heavy dependence of the economy on imports. The reality was quite different, however. While consumer goods imports were reduced substantially, this was achieved at the expense of increased reliance on imported capital goods and raw materials, resulting, contrary to expectation, in an even more rigid dependence on imports. Given these structural features, the growth dynamism of the newly established industrial sector tended to show a close functional relationship with the fortunes of the traditional export industries. Thus, unanticipated import curtailments brought about by foreign exchange scarcity turned out to be the main constraint on industrial expansion from the late 1960s. Moreover, the ‘inefficiency spillover effects’ of spillover effects (SOEs) involved in intermediate goods production on private sector end-user industries were quite substantial, particularly since import compression policies were implemented with a distinct bias towards SOEs in the allocation of foreign exchange (Athukorala and Jayasuriya 1994). In most developing countries rapid expansion of domestic industry continued until the ‘easy’ import-substitution opportunities (i.e. meeting domestic demand in textiles, footwear, some food processing and other light labour-intensive activities) were used up. It was only then that the cost of additional investment in new IS activities began to rise and growth slowed down (Krueger 1992:43–44). However, in Sri Lanka, a limit was set on the growth of industry by the balance of payments constraint well before the completion of the easy IS phase.

General dissatisfaction with stagnant economic growth, deterioration in the provision of social services, rising unemployment, shortages and widespread rationing of consumer goods, together with opposition to increasing authoritarianism in the political arena, set the stage for a change in the political regime. At the general elections of July 1977 the centre-right United National Party (UNP) scored a sweeping victory on a platform of opening up the economy and revitalising the private sector. The first round of reforms carried out during 1977–79 included significant trade liberalisation, revamping the foreign investment approval and monitoring process with new incentives for investors, a significant interest rate reform and opening of the banking sector to foreign banks, limits on public sector participation in the economy and exchange rate realignment.

The extent of ‘outside influence’ on the 1977 policy shift towards economic liberalisation remains a debatable issue. From time to time newspapers interpreted the policies as a positioning for receipt of Western aid, and contended that in 1977 the International Monetary Fund (IMF) and World Bank became Sri Lanka’s ‘new masters’. There is little doubt that following the policy reforms foreign aid to Sri Lanka from Western countries increased significantly and the presence of the IMF, World Bank and other international agencies in the policy scene became prominent. However, one judgement commonly made by Sri Lankan government officials and some economic observers is that, given the dismal economic record of the closed-economy era, even a re-elected centre-left government would have embarked on a similar reform process. Indeed, there was considerable discussion within government circles during the immediate pre-election years on the liberalisation of the trade and foreign investment regimes.²²

The impact of 1977 policy reforms on economic growth was dramatic; average annual GDP growth rate more than doubled from 2.9 per cent during 1970–77 to 6 per cent between 1978–83. However, this growth surge could not be maintained in the subsequent period, primarily because of a collapse of political stability. From 1984 onwards Sri Lanka has been subjected to a secessionist war in the northern and the eastern provinces, while a radical youth uprising gripped the rest of the country in the late 1980s. In this volatile climate, there was little room for attempts to complete the unfinished agenda of economic liberalisation.

Political instability resulted in severe economic dislocation, and a sharp escalation of defence expenditures, which, in turn, led to widening fiscal deficits, growing macroeconomic problems and erosion of international competitiveness of the tradable sectors. Apart from continued fiscal expansion triggered by the civil war, the drying up of official capital inflows (with the completion of aid-funded public sector investment projects) also contributed to major macroeconomic imbalances. By the end of 1988, official foreign exchange reserves had fallen to the equivalent of six weeks’ imports, while the service payments on external debt had risen to 28 per cent of export earnings. Average annual GDP growth during 1984–89 was only 2.6 per cent. In this context, the government, under pressure from the Bretton Woods institutions, agreed in June 1989 to implement a ‘second wave’ liberalisationcum-adjustment package. The programme basically aimed to arrest the deteriorating external payments position and control inflationary pressures by bringing down the fiscal deficit and moderating the rate of monetary expansion. The policy package included an ambitious privatisation programme, further tariff cuts and simplification of the tariff structure, removing exchange controls on current account transactions, commitment to a policy of flexible exchange rate management and initiatives to cut the fiscal deficit.

After seventeen years in government, the UNP lost power at the 1994 general elections to the People’s Alliance (PA).³ The election result was largely determined by the growing disenchantment with the trend towards authoritarian methods of rule and a culture of ‘crony capitalism’, the continuing civil war, political violence and rampant corruption. In fact, during the election campaign it became clear that an unprecedented consensus had emerged across all mainstream political groups over the superiority of market-oriented polices pursued since 1977 and the need for continuation of pro-market, liberal economic policies to achieve economic development.

There was speculation at the time of the election that if the PA came to power, it would decelerate, if not reverse, the liberalisation process. But, the actual course of policy under the new government has been quite the opposite. The liberalisation process, particularly in the privatisation area has, if anything, accelerated under the new regime. The inaugural policy statement of the new government has provided assurance that economic policy will in general be market friendly and the private sector will be considered the principal engine of growth (Government of Sri Lanka 1995a). The new government is committed to reducing progressively and harmonising tariffs towards a single rate of 10 per cent over the medium term (Government of Sri Lanka 1995b).

With this background we now discuss in detail the key elements of the trade and foreign investment policy in Sri Lanka as they have evolved since 1977.

Trade policy

Trade policy reform was the key element of the economic liberalisation policy package introduced in 1977. In November 1977 quantitative import restrictions on imports, which were near universal, were supplanted by a revised system of tariff, retaining only 280 items under licence. This far-reaching change was accompanied by the removal of most price controls on domestic trade. While many of the tariff changes involved a gazetted increase in the rate, the tariffication typically involved a sharp reduction in the degree of protection provided previously by the stringent quantitative restrictions (QR) regime. Further, in practice, the retention of some...

Table of contents

• COVER PAGE
• TITLE PAGE
• COPYRIGHT PAGE
• FIGURES
• TABLES
• PREFACE
• INTRODUCTION
• PART I: TRADE POLICY AND DEVELOP MENT
• PART II: FOREIGN INVESTMENT AND EXPORT-ORIENTED INDUSTRIALISATION
• PART III: EXPORT ORIENTATION AND THE WORLD ECONOMY
• REFERENCES