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China’s easy money comes with strings attached – KPMG India chief warns Sri Lanka

September, 13, 2018

Arun Kumar, Chairman and CEO of KPMG in India, says the ‘easy money’ which is offered by large economies like China to smaller nations the likes of Sri Lanka often comes with strings attached such as the loss of control over natural resources.

Delivering the keynote address at the Sri Lanka Economic Summit 2018 on Thursday (13), he said that given that large economies in Asia such as India and Japan cannot fund Sri Lanka’s large infrastructure needs fully, Sri Lanka has looked to cooperate more closely with China.

“But often, this easy money which is offered comes with strings attached – unsustainable debt (as has been in the news lately), decreased transparency, restrictions on market economics and a loss of control over natural resources,” he cautioned.

Full text of speech:

 

Good morning.

It is a great honor for me to be with you, and as always, a pleasure to return to your beautiful country. I will share with you some perspectives based on my experience in trade and investment in the Obama Administration in Washington and my subsequent eighteen months based in India as Chairman and CEO of KPMG India.

On my first visit to Sri Lanka, a couple of years ago, representing the US Administration when I served in Washington, I related an episode of trade from Sri Lanka’s history. Ice used to be cut from the frozen lakes of New England, significantly from Walden Pond outside Boston, covered with salt and sawdust to lower their melting point, and would be shipped out to Sri Lanka and India. On the return voyage, from Sri Lanka, the ships would carry graphite which would be made into lead pencils that American school children would write with.
Walden Pond became famous when Henry David Thoreau the philosopher wrote his book, Walden. It turns out that Thoreau worked in his family’s pencil factory shaping Sri Lankan graphite into pencils.

This is, to my mind, a story of the connections we find in our world. Everyone and every country is connected in some way. “No man is an island” said John Donne, the English poet, we are all connected with one another.

And this applies not just to people, it equally applies to an island nation. In today’s world, more than ever before, we need to be connected – ideally with open economies operating according to common rules.

This connectivity has perforce to be at the center of any economic strategy in today’s world and applies even more to Sri Lanka given its geographic situation.

Eight years after the end of a long civil unrest, the Sri Lanka economy has grown on average at a rate of 5.8 percent a year.  While there have been signs of a slowdown in the last three from a peak of 8% in 2009 to 3.1% in 2017, there are many indicators to suggest that things do look bright from here on.

There are a few matters to keep in mind when we discuss what needs to be done:

  1. In the 70-80s investment in the tradable sectors led the productivity boost. Post the civil war, investment was mainly driven by mega-scale public-financed infrastructure projects, and did not seem to result in immediate productivity gains -- as reforms to enable the business environment lagged.
  2. Sri Lanka’s static export structure signifies an absence of competitive forces to drive trade dynamism, innovation, and diversification; for over two decades exports have remained concentrated on garments, tea, and rubber products with a declining share in global trade.
  3. Introduction of para-tariffs barriers during the last decade has effectively doubled the protection rate, making the present trade regime one of the most complex and protectionist in the world. Despite operating a complex and an expensive system of tax incentives to promote investment, FDI remains low.

However, over the last couple of years, efforts are being made to transition the economy from a predominantly rural-based economy towards a more urbanized economy oriented around manufacturing and services.

To that end, Sri Lanka’s new Vision 2025 sets out a course of reforms to make the country more competitive and lift the countries’ standards of living.

 

Structural weaknesses, limited export performance, constrained public finances and regulatory barriers to investment are some of the macro economic issues which have impacted growth over the years.

Let me discuss five interconnected topics for consideration as Sri Lanka aims to steer into a trajectory of sustained growth.

  1. First, trade, especially exports. With a domestic market of 20 million customers and a modest per capita income, Sri Lanka needs an aggressive external trade policy to fuel its resurgence. External trade is critical to small countries – and to large countries. When you are a small country, the challenge is that it is not possible to build prosperity with a small market. Whether it is Sweden, with half the population of Sri Lanka, or South Korea with two and a half times the population, it is clear that exports are critical to growth and prosperity. I can tell you that in the United States, the largest economy in the world, where I served as President Obama’s lead official to increase exports and inward investment, we saw exports as critical to the growth of employment. Trade is thus one of the most critical reform areas to be addressed on the path to a turnaround. And regional integration is a key element to facilitate increased trade.
  2. Second, investment, especially foreign direct investment (FDI). There is an urgent need to catalyze domestic investment and attract FDI in order to grow and create more jobs. Sri Lanka attracts a much lower volume of FDI than peer economies. Sri Lanka can take a leaf from India’s book; there, a liberalized FDI regime with automatic approvals with some exceptions has resulted in it becoming a prime destination for FDI.
  3. Third, connectivity – policies and investments to promote regional cooperation and integration -- should be a key strategic priority. Such integration should extend to energy, logistics, transportation, communications and harmonized standards.

 

  1. Fourth, investment in growth oriented infrastructure and logistics is imperative to make Sri Lanka an economic hub in South Asia.
  2. And finally, balancing geopolitical partnerships – specifically those with China and India.

Trade

For a small country with a small domestic market, external trade is imperative to achieve high growth. External trade depends on being competitive.

According to trade policy indicators recently developed by the IMF, Sri Lanka’s trade and FDI regimes are more restrictive than the average emerging market across key areas. These restrictive policies translate into weakness in trade competitiveness.

In particular, the country is more distant from the emerging market average in the categories of trade facilitation performance and ease of starting a business. Instead, in both these areas, Sri Lanka should aim to do very well.

The World Economic Forum’s Enabling Trade Index 2016 scores Sri Lanka at 4.1 out of 7 mainly due to market access, tariff rates and tariffs faced in destination markets.

An abundance of literate labour is a major asset and has got to be the basis of Sri Lanka’s comparative advantage and trade.  In such a scenario, where such talent should be applied to creating competitive value added products for export, protectionist policies will weaken competitive impulses and lower trade. One only has to look north to India’s experience, where, after the opening up of the economy in 1991, trade increased and economic growth and per capita income surged.

The rationale for economic openness in Sri Lanka is compelling.

Back in 2005, trade accounted for close to 80% of GDP; today it hovers around 50% which is the same as India, but India has a huge domestic market.  Compare Sri Lanka to some other leading regional economies that are doing well: Vietnam’s trade-to-GDP ratio is now around 170%, Malaysia’s is 150%, and Thailand’s is 120%. Of course Singapore is an outlier at 350%, but these figures all indicate the degree to which trade drives growth in those economies.   

Moreover, a significantly high state participation in the economy has had implications on competitiveness in a number of sectors and labor market dynamics.

In addition to mastering trade, the country also needs a more diversified export basket beyond garments and cash crops and foreign investment into the more productive manufacturing and services sectors with links to global value chains.

And not just with the U.S. and Europe – where the bulk of Sri Lanka’s current trade is directed today (45% of exports). This is largely due to the preferential access that Sri Lankan exports get in these markets through Generalized System of Preferences (GSPs). The GSP should not become a long term dependency; it is important to become competitive without the support of the GSP. Furthermore the GSP itself should have encouraged Sri Lanka to seek greater preferential access in other markets by striking trade deals. But surprisingly, Sri Lanka’s FTA dossier is limited to one completed (Singapore) and another five bilateral deals on the anvil —India, Pakistan, Israel, Singapore, Iran and Egypt.

This leaves a vast untapped potential in the neighbourhood, including what can be achieved by creating comprehensive links with what is today the third or fifth largest market in the world by many measures. India’s economy, in dollar terms, has just surpassed that of the UK. This large market has to be a major focus for Sri Lanka.

Steps to increase trade

In order for an economy the size of Sri Lanka to be able to generate and sustain economic growth, inward investments and lowering of barriers to competition in key domestic sectors will be important.

The New Trade Policy (NTP), approved in July 2017 aims to stimulate growth by improving the ability of firms to export and to compete for the domestic market through a modern, liberal, simple, transparent and predictable trade regime. Let me share some observations.

  • It is critical to recognize the importance of trade capacity building. According to the Economic Census, 99% of all establishments in this country are micro, small and medium enterprises. Enabling the SME segment to participate in global value chains by helping increase their ability to compete in export markets needs to be a fundamental step.
  • Such capacity building will help Sri Lankan businesses take advantage of the FTAs and bilateral agreements which are under negotiation.
  • The legal system has to be modernized. Countries like the UK, US, Canada, Australia, Singapore and now India have successfully incorporated Alternate Dispute Resolution mechanisms into their legal systems. Legislation should be enacted to empower judges to vigorously encourage civil litigants to resort to resolve their disputes using ADR through channels like mediation, negotiation, arbitration and reconciliation.

Training opportunities should be created for those who are interested to learn the skills necessary to serve as ADR professionals.

  • Developing adequate compliance infrastructure is also a requirement. Strong commercial law and intellectual property protection mechanisms, especially in the above areas are incredibly important for improving the ease of doing business.  This will in turn increase FDI and smoother operations for local companies.
  • Sri Lanka can also look towards working with development institutions such as the UNIDO, ADB and the World Bank for assistance. The revival of Sri Lanka’s cinnamon trade in terms of market share, redefining standards and competitiveness is a good example of the results of such past assistance.
  • Sri Lanka has had its share of successes. The government’s role in promoting and orchestrating the tourism sector, especially in the areas of price competitiveness and safety, is an example.
  • Trade facilitation measures such as a single electronic window will help reduce transaction costs of the cross-border movement of goods thereby enhancing the trade competitiveness of the economy.

 

Regional Integration

Such measures will, most importantly, also lead to better integrating Sri Lanka in the region.

Improving physical connectivity between South and Southeast Asia has long been recognized as a key element in promoting greater trade and investment linkages within the region.

In India, Prime Minister Modi has stated that “A nation's fortunes are linked to its neighbourhood.  No nation is too large to not need her neighbours.”

Measured by intraregional trade in goods, capital, and ideas, South Asia is the least integrated region in the world. Intraregional trade as a share of total trade is the lowest for South Asia. The flow of ideas, crudely measured by the cross-border movement of people, or the number of telephone calls, or the purchase of technology and royalty payments, are all low for South Asia.

So, while South Asia has made significant progress in integrating with the global economy, integration within the region remains limited, primarily due to fears emanating from the varying size of economies.  Sri Lanka can play a lead role in changing this.

Both India and Sri Lanka are members of SAARC, the Indian sub-continent’s equivalent to ASEAN, which offers tariff reductions between members.  While this regional initiative has seen some progress, a lot more can be done.

There are already powerful examples in Asia that show us that differences in size is no constraint to beneficial partnerships, if we use each country’s strengths depending on the opportunities.

As an island economy, Sri Lanka's regional connectivity has been mainly through its main sea port in Colombo, a transshipment hub port for South Asia.  To expand capacity, the country must engage private investment in infrastructure by strengthening the country's institutional and regulatory environment.

Active participation in the South Asia Association for Regional Cooperation (SAARC), the Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation (BIMSTEC), and the South Asia Subregional Economic Cooperation program (SASEC) can help build further connectivity with neighboring countries, and the rest of Asia.

Foreign Direct Investment

Foreign investment needs to be a high-priority area for growth and employment generation. India has set an example in the neighbourhood. With progressive FDI policies and an activist approach to inviting investment, India has become one of the largest destinations of foreign investment.

When I served in the Obama Administration, I also had oversight of SelectUSA, the Federal government’s investment promotion organization. A country as economically vigorous as the US still recognizes the value of foreign investment for job creation and advancing competitiveness.

Sri Lanka’s foreign investment has remained below 2% of GDP over the past twenty years.  In addition, new FDI in the past few years has been predominantly infrastructure oriented with only a relatively small proportion reaching sectors that are associated with global value chains.

Private sector investment has remained constrained because the business environment has not been conducive and the public sector has played a dominant role in the past.  Since the government’s budgetary resources are limited, the private sector is expected to play a larger role in infrastructure development through PPPs. Policies to improve the investment climate, complemented by upgrades in the quality of infrastructure and human resources, need urgent attention to catalyze domestic investment and attract FDI.

Breaking from the past, Sri Lanka’s new Inland Revenue Act, approved in October 2017 aims for a transparent, unified, and even-handed legal framework. Consistent implementation of this new rule-based system could help unlock long-term investment decisions.

More generally, it is vital to cut the red tape hampering businesses to attract greater FDI from a various sources.

KPMG India has worked extensively with the Governments of various states in India in the area of investment promotion. Sri Lanka could adopt best practices from the various states’ investment promotion boards to restructure Sri Lanka’s Board of Investment, towards purely promoting FDI and away from regulating FDI and managing export processing zones.

The work involved in promoting FDI has many dimensions. For example, KPMG India has undertaken extensive work with respect to development strategy  -- in  theIT/ ITeS sector in the state for U.P. to articulate the Government’s IT Policy, market potential studies such as to promote investment in the Delhi Mumbai Industrial Corridor (DMIC), roadmap and vision development for infrastructure development in various sectors in Punjab, and so on.

Ease of Doing business is increasingly a key diagnostic parameter for global investors today. In India, KPMG has been working actively with India’s Department of Investment Policy and Promotion (DIPP) as well as with many states to help measure and improve Ease of Doing Business.

India, as you all would know has made a remarkable improvement in its ease of doing business rankings this year, a 30 - place jump, higher than any other country.

This jump was driven by improvement in many parameters like construction permits, paying taxes and insolvency resolution. Most importantly, it is the relentless implementation and on-ground results which made all the difference.

Sri Lanka also is on a similar path – with the government having fast-tracked the progress of many business-friendly reforms with an aim of moving 20 notches higher in the World Bank’s Ease of Doing Business Index for 2019, from the 111th slot currently.

Combating corruption and unfair market practices should be at the heart of improving EoDB. To this end, Sri Lanka should have a strong national framework for public services complaints. A good example is that of Indonesia’s public complaints’ unit, LAPOR (meaning report.)

Infrastructure

Moving on, to the fourth central theme – infrastructure.

Sri Lanka has been successful in developing basic infrastructure. It has the highest road density in South Asia, 98% of the population has access to electricity, 96% access to safe water, and 95% access to sanitation. But Sri Lanka ranks a relatively low 73 (out of 138 countries) for infrastructure development in the Global Competitive Index, 2016–2017.

Thus, given its aggressive ambitions, there is a requirement to further invest in growth oriented infrastructure like energy, transport and urban development.

During the period 2018–2022, infrastructure investment needs are estimated to be $5 billion–$6 billion per year to attain the government’s economic growth target.

The capacity of the government to increase infrastructure investments is currently constrained by a difficult fiscal situation.

It is notable in this context that Sri Lanka is focused on this area with support from multilateral development banks like the ADB to improve road, port and railway connectivity.

Further, there is a dire need, as in India and many developing countries, to leapfrog over decades old infrastructure and modernize the energy sector by investing in smart grids, efficient technologies and mobile apps for electricity payments.

Today, Asia invests $881 billion in infrastructure overall – barely half of what is needed.  Over the next 15 years, this need will be four times the current investment.

 

Adequate infrastructure is not only necessary for accelerating economic growth, but it is also a prerequisite to achieve better health, education and other development outcomes.

 

Fiscal reforms to enhance sustainability of government finances and public infrastructure investments need to continue.  There is also a requirement to create a governance mechanism to implement projects successfully.

Legal frameworks, regulatory policies and strengthening the overall policy environment is imperative.  Engagement with private sector to boost efficiency of infrastructure services can also be explored.

These reforms will ultimately enhance Sri Lanka’s ability to address border and behind-the-border barriers to enhance cross-border collaboration infrastructure (e.g., harmonization of regulatory standards).

Indo-Pacific and Sri Lanka

Staying on the topic of beyond the border connectivity, a ‘free and open’ Indian ocean is at the core of the emerging Indo-Pacific view of the world.

The Indo Pacific paradigm recognizes deepened connections between the Indian Ocean region and the Pacific, from the shores of Africa to the West coast of the Americas.

Sri Lanka is physically a veritable attractive diadem in this picture of the Indo Pacific.

Many countries, notably China, India and Japan, are seeking a greater role in developing Sri Lanka’s strategic location between the energy-rich Middle East, Africa and the Straits of Malacca.  The U.S. too is not far from considering Sri Lanka a strategic bulwark.

Sri Lanka, no doubt, would want to make the best of its attractive location by fashioning itself as a potential trade and finance hub open to doing business with everyone – thus taking it closer to its economic vision.

But, it will be a delicate balancing game.

 

China

Historically, Sri Lanka has had close relations with China and seeking to renew those connections would seem to be the natural thing to do.

The recent expansion of China’s economic and military reach has caught international interest – given China’s principle of active defence and history of acting in self-interest. Sri Lanka should of course be fully conscious of this.

Access to an industrial park in Sri Lanka and management of the Hambantota Deep Sea Port and International Airport are seen as signs of China asserting itself at the international high table. These are also perceived as indications of Chinese designs to buy influence by creating logistics bases globally and, alongside, lock up access to strategic resources.

Port City Colombo, financed by China, promises to be a game-changer for Sri Lanka, and the government hopes its development will help Colombo become an enhanced trading hub between Europe, Africa, the Middle East and Asia.

The port will also be a finance centre accessing the Indian subcontinent’s rapidly developing markets, hopefully attracting overseas investors and increasing employment.

Given that large economies in Asia such as India and Japan cannot fund Sri Lanka’s large infrastructure needs fully, Sri Lanka has looked to cooperate more closely with China.  But often, this easy money which is offered comes with strings attached – unsustainable debt (as has been in the news lately), decreased transparency, restrictions on market economics and a loss of control over natural resources.

Internationally, the Bridge and Road Initiative, into the designs of which Sri Lanka falls, has been viewed with suspicions by some that this global investment and lending program amounts to a debt trap for vulnerable countries around the world, fueling corruption and autocratic behavior in struggling countries.

It is important in this context for Sri Lanka to take a well-informed approach to also engage with the rest of the economies in the region.

Finalizing free trade agreements (FTAs) with many of the major regional powers over the next year or so would be desirable as balancing and enhancing measures.  Among these are the Economic and Technology Cooperative Agreement with India and FTAs with other countries.

The Sri Lankan government’s turn towards broader engagement with East Asia recognizes the country’s pivotal position as a strategic asset to both India and China.

Asia and the world will have a better future when the large economies work together, being sensitive to each other’s interests. What would it take for Sri Lanka to be that Switzerland of Asia where the major countries work together?

 

India

India of course is Sri Lanka's closest neighbour. The relationship between the two countries is more than 2,500 years old and both sides have built upon a legacy of intellectual, cultural, religious and linguistic intercourse. In addition to the historical connections with India of Buddhism, Sri Lanka also has an ethnic Tamil diaspora that has deep linkages with Indian people in the state of Tamil Nadu.

Many Indian origin diaspora have resided in its southern neighbour for decades now.  They in fact, form an important link between the Indian and Sri Lankan people and the government.

Most importantly, India is a vibrant and growing economy with a large market of 1.3 billion people offering rich opportunities for exports and investments. India, by virtue of its proximity, is also its natural trading partner.

Beyond that, both are democracies.

Relations between the two countries have also matured and diversified with the passage of time, encompassing all areas of contemporary relevance and the extensive people to people interaction of their citizens provide the foundation to build a multi-faceted partnership.

 

 

Conclusion

Sri Lanka has gone through defining transitions over the past decade.

Despite significant productivity growth in the post-war period, it has been challenging for Sri Lanka to diversify exports and its share in global trade has been declining gradually.

Unlike its East Asian neighbors, Sri Lanka’s export structure has been static for years, reflecting a lack of competitive forces to drive trade dynamism, innovation, and diversification.

When I interact with investors and trade delegations from around the world, overwhelmingly, Sri Lanka’s geographic location and access to regional markets are cited as top reasons for their interest in the country’s economy.

Sitting in the middle of the Indian Ocean off the southern tip of India, Sri Lanka occupies an enviable strategic position. A blessing that, with careful and thoughtful handling and long term vision, and a commitment to openness, can be leveraged to its advantage.

Leveraging the island’s geostrategic positioning can be a game-changer for economic growth.

Reforms to ease the business environment and trade, now at the early stages of implementation, can become catalysts and enablers for accelerated growth. Other countries that have pursued infrastructure scale-up have learned that business environment liberalization is also required for private sector led growth.

To this end, the current economic environment offers a window of opportunity for evaluating structural weaknesses and working towards enhancing competitiveness.

Clearly, the Sri Lankan Government is focused on making the country more open to the world and becoming an attractive place to do business.

The key as we have seen in India is that the leadership places relentless focus on execution. Sustained commitment will be required to see reforms through.

I once again thank the members of the Ceylon Chamber of Commerce for giving me this opportunity to be here.