Reflections on economic development policy perspectives

Sunday, June 28, 2020

A plethora of economic policy recommendations to revive the economy and achieve economic growth has emerged. The general thrust of these is that the country needs to pursue different policies after the dislocation of the global economy by the COVID-19 pandemic.

Recommendations

Individuals, professional groups, research organisations and concerned citizens have written articles, submitted proposals, presented studies and memoranda on how the economy or a key sector should be developed. Most of these recommendations are based on the premise that the economy should be re-modelled and that a new path or model of economic development is needed. However many of these are ideological and not pragmatic. They are often an overreaction to the global recession brought about by the COVID-19 pandemic.

Fashion

It is fashionable to be against the policies pursued in the recent past. The impact of COVID-19 must be differentiated from the fundamental principles of economic growth and development. Overreaction to the disastrous effects of the COVID-19 pandemic could result in policies that aggravate economic problems. It could be likened to ‘throwing the baby out with the bathwater.’

Good economics

There are only two kinds of economics–good and bad economics. Good economics achieves the goals and objectives of growth and development. Bad economics fail. The iron laws of economics are like gravity, you cannot change them. You can take actions to ameliorate the results with countervailing policies, but cannot prevent the consequences of economic actions.

For instance, if the money supply is increased without a commensurate increase in goods and services there will be inflation. Similarly, large fiscal deficits would result in increased debt servicing costs, inflationary pressures and reduce international competitiveness.

Neo-liberal label

One of the deficiencies of current Sri Lankan thinking on the economy is to label economic policies and repeatedly attack them. Frequently criticised policies are described as “neo-liberal policies”. The criticism is for the whole gamut of policies that most economies have pursued in recent decades with much success. The implication of this mode of thinking is that all free market policies are bad for the economy. The new policies advocated may worsen the problem.

Does this mean there is a need to pursue inward-looking economic policies? Should we ban most imports and produce these at home? Should we ignore the theory of comparative costs and once again attempt to produce almost all our requirements locally?

Import substitution

It is certainly popular to advocate import substitution and import restrictions. Undoubtedly, there is an economic rationale in banning certain imports. For instance, the recent ban on car imports is a case in point. This will reduce import expenditure without harming exports.

There are other imports too that could be restricted without an adverse impact on the economy and benefit the balance of payments. However an extensive ban on so called non-essential imports could cripple the economy as it did in the 1970-77 period and limit exports.

Policies in 1970-77

The memories of the failure of inward looking policies of 1970-77 are not in the minds of most people as it was around 50 years ago. Those policies led to a stagnant economy with low economic growth, industrial inefficiency and low utilisation of industrial capacity. It was a period of scarcities of basic needs. One could characterise it as a period of shared poverty.

In jettisoning “neo-liberal policies” are we moving towards proven failed economic policies? Nevertheless the political rhetoric of condemning “neo-liberal” policies pursued since 1977 and a call for import substitution are popular political slogans.

Import substitution is bandied about as the panacea for our balance of payments difficulties. It is not uncommon for law makers to proclaim that they would resolve the country’s large trade deficit by banning imports and ensuring import substitution. Import substitution is music in the ears of the public most of whom believe that the country is rich in resources and can produce most requirements, especially all food requirements.

Rationale of import substitution

The economics of import substitution and its limits are little understood. The rationale of import substitution is that when there is a potential to increase production with a price incentive and protected market for an initial period such protection is beneficial. If such protection continues over a long period, then consumers would have to pay higher prices, there may be shortages and the quality of the product inferior. This was the case in many industries that were protected in the 1970-77 period.

India

It was the case in India too. With its stringent import restrictions and a local market for whatever it produced, India was unable to export its industrial manufactures despite its rich resources of raw materials. It was after the liberalisation of trade and investment that India was able to export manufactured goods, including cars.

Liberal trade

Unfortunately, we have limited resources. The economic rationale for liberal trade policies is stronger for a small country with limited raw materials and small domestic market than large countries. However large countries like India and China have benefitted from liberalised trade.

Failure

Similarly, Sri Lanka failed to diversify its exports and remained mainly an agricultural exporting nation till the late 1970s. Manufactured exports were only 14.2 percent of total exports. Agricultural exports were 79.2 percent of total exports. In contrast, in 2019, manufactured exports exceeded agricultural exports. It was only after the liberalisation of the economy that exports of garments, rubber goods and other manufactured goods expanded.

However the actual significance of agricultural exports compared to manufactured exports is higher as the domestic value addition is much higher than in manufactured goods with a high import content.

Import content

The fact that manufactured exports have high import content implies that a free import of raw materials is essential for exports. If there are restrictions on imports of raw materials or high taxes export industry competitiveness would be eroded. This is why countries with liberalised trade such as South East Asian countries, Vietnam and Bangladesh have achieved success as exporting countries.

Growing protectionism

Sri Lanka too provided an economic environment after the liberalisation of 1977, but over time increased protection owing to imposition of various charges on imports that have increased import costs. It is vital that these para-tariffs are removed for raw materials.

Misconception

A popular misconception is that there are manufactured exports for which there is little need for imported raw materials. The manufacture of tyres is considered such an export industry. In fact tyre manufacture requires imported synthetic rubber, canvas, metal wires, chemicals and machinery and spare parts. Consequently manufacture of even tyres has a high import content. Yet, the manufacture of tyres is  a success story as Sri Lanka is the largest manufacturer of solid tyres in the world.
Another misconception is that imports of food could be taxed in order to give protection for domestic food production to achieve food self sufficiency. In fact the inadequate production of many food items such as sugar, is not due to a price incentive. The consumer price of sugar is excessively high compared to international prices. There are fundamental and structural reasons for the inability to produce sugar at a competitive price. These must be resolved to produce a much higher amount of sugar.

Cost of living

The imposition of import duties on basic foods increases the cost of living and in turn, the costs of production. An important reason for our non-competitiveness in labour intensive industries is higher wages compared to Vietnam, Bangladesh and India. This is also a reason for the inability to attract FDI.

Conclusion

Sri Lanka’s economic future lies in increasing and diversifying exports, not limiting imports. Economic policies must ensure this.