Sri Lanka In the Year 2000 An Agenda for Action · 2016. 7. 17. · 6. To strengthen growth, the...

Report No. 15455-CE

Sri LankaIn the Year 2000 - An Agenda for Action

March 14, 1996

Country Operations DivisionCountry Department ISouth Asia Region

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SRI LANKA IN THE YEAR 2000AN AGENDA FOR ACTION

TABLE OF CONTENTS

Page No

Executive Summary .................. i

I. INTRODUCTION .............................................. I

II. ACHIEVING SUSTAINED, RAPID GROWTH ............................. 3

A. Promoting Growtlh -- Interinational Experience and Lessonsfrom the Past ............................................... 3

B. Improving Macroeconomic Management ................................ 5C. Strengthening the Civil Service .................................. 12D. Promoting Private Activity and Employment . ........................... 18E. Improving Energy and Infrastructure ................................. 22

Ill. LABOR MARKETS AND EMPLOYMENT ....... ....................... 24

IV. THE AGENDA IN HUMAN RESOURCES ........ ...................... 28

A. Education ..................................................... 28B. Health and Nutrition ............................................. 30

V. REFORMING THE SOCIAL WELFARE PROGRAMS ....... .. ............ 33

VI. SRI LANKA'S ECONOMIC GROWTH ......... ........................ 36

ANNEX ......................................................... 38

This report is the product of a team of Sri Lankan policy analysts and practitioners and World Bank staff. The Sri Lankan side of theteam, coordinated by Dr. Lal Jayawardena (Economic Advisor to the President and Deputy Chairman, National Development Council).includes Dr. Chandi Chanmugan (Member of the Monetary Board and Institute of Policy Studies), Dr. L. Gunaratne (Director ofResearch, Central Bank of Sri Lanka). Dr. W. Hetteriachchi (Executive Director, Central Bank of Sri Lanka and coordinator of the SriLankan part of the team before being assigned to the IMF in Washington), Dr. R.M.K. Ratnayake (Secretary, Ministry of Sports, Youthand Rural Development), Dr. P. Ramanujam (Director General, Secretariat for Infrastructure Development and Investment), T. Maxwell(Consultant, Ministry of Industry) and Mr. N. Tiruchelvam (Partner. Tiruchelvam Associates). Mr. A.S. Jayawardena (Governor of theCentral Bank) initially led the Sri Lankan team and guided the study throughout. Dr. S.A. Karunaratne (Director General, NationalPlanning Department), the staff of the Planning Department, Dr. P.B. Jayasundera (Deputy Director of Research, Central Bank of SriLanka), Dr. S. Kelagama (Executive Director, Institute of Policy Studies) and Dr. Sisiva Jayasuniya (Professor of Economics, Universityof Melbourne), all deserve special thanks for their thoughtful comments. On the World Bank side, the team included P. Alba (TaskManager), S. Lateef. M. Prywes, C. Hartler, R. Nangia, A.G. Karunasena, V. Iyer and C. Kanda.

Page No

LIST OF TABLES

Table 1: Adjustment and Growth in Sri Lanka ......... ........................... 4Table 2: Overview of the Labor Market .. ...................................... 25Table 3: Uneinployment Rates by Group: Q4 1993 ................................ 26Table 4: Key Economic Indicators Under Adjustment .............................. 39

LIST OF FIGURES

Figure 1: Fiscal Sustainability ................................................. 8Figure 2: Projected Incidence of the Wheat Flour Subsidy in 1995 ...................... 35

LIST OF BOXES

Box 1: Economic Adjustment, Growth and Income Inequality. 2Box 2: Thle Benefits of Macroeconomic Stability. 6Box 3: Capital Flows and Macroeconomic Policy. 9Box 4: Building a Structure for Stability .10Box 5: Building Institutions: The East Asian Experience .13Box 6: Report of the Administrative Committee - Extracts .15Box 7: Finanicinig Higher Education .31Box 8: Back to the Future - Evolution of Targeting of Social Transfers .34Box 9: Successful Targeting of Social Transfers in Developing Countries .36

BIBLIOGRAPHY

EXECUTIVE SUMMARY

Introduction

1. Sri Lanka has achieved remarkable success in human development. The level of socialdevelopment, as measured by key indicators such as life expectancy and adult illiteracy rate, is well ahead ofother countries at similar income levels, and stands out even compared to middle-income countries. Whilegood initial conditions helped, Sri Lanka's success is mainly the consequence of continuous emphasis on humandevelopment since Independence, including a tradition of providing generous safety nets.

2. That success has not been fully matched on the growth side. While Sri Lanka's long-term per-capita growth has been good (about 2.8% p.a. on average between 1961-93) compared to other low incomeeconomies, it has been below potential. While Sri Lanka emphasized education and health like the moresuccessful of its East-Asian neighbors, stop-and-go economic policies have had a dampening effect on growthand the ability to utilize fully its human resource base. Indeed, growth is the weak link in Sri Lanka's povertyalleviation strategy. A stronger growth performance comparable to the more successful Asian economieswould have led to deeper reductions in poverty whose incidence remains of deep concern. In spite of recentgains in growth and employment, it is estimated that in 1990 some 20% of Sri Lankans lived in absolutepoverty.

3. And tragically, that success has been marred by a tragic ethnic conflict that has exacted a highcost in human lives and suffering and has directly and indirectly severely sapped growth prospects. The warhas caused large scale destruction of economic and social infrastructure, reduced private sector confidence andinvestment, reduced foreign exchange revenue, and has diverted a large proportion of national resources intomilitary uses.

4. The recent changes in Sri Lanka's political scene has opened new opportunities for taking a freshlook at Sri Lanka's development challenges and elaborating a responsive strategy. Most positively, theGovernment has taken courageous steps to seek to end the war, even if these efforts have been frustrated.While the recent renewal of hostilities is a terrible blow to the peace process, the Government remainscommitted to a negotiated settlement. Peace would set the stage for a sustained economic boom ifcomplemented by appropriate development policies and programs. These should serve the Government'sobjectives to boost growth and employment, and preserve Sri Lanka's edge in human development whichwould also help ensure widespread distribution of the benefits of rapid growth.

5. This report, a product of a team of Sri Lankan analysts and World Bank staff, elaborates policiesto address how to increase the growth rate, including strengthening macroeconomic management, removal ofobstacles for private sector development, and raising the efficiency and implementation capacity of the publicsector. On the human development side, the report looks at how to increase employment in a sustainablemanner, and improve the quality of basic human services and the targeting and cost-effectiveness of povertyprogranms. The matrix attached to this Executive Summary enumerates the main policy recommendations of thereport.

Raising the Growth Rate

6. To strengthen growth, the Government's priorities are to achieve lasting peace and resumeadjustment efforts. It is difficult to over-rate the consequences of peace. In a nutshell, peace is essential tosustain private confidence in Sri Lanka's economic prospects, to restore the productive capacity of the Northand East, to fully exploit tourism potential, and to reduce macroeconomic imbalances and release resourcestowards productive uses. Without peace, Sri Lanka is unlikely to emulate its dynamic East Asian neighbors.

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With the advent of peace, the growth potential will increase dramatically. However, the peace dividend in theshort-term will likely be small, and increase only to the extent that longstanding policy deficiencies are tackled.These weaknesses are made more acute by the large fiscal slippages and the lack of progress in implementingstructural reforms during the election year of 1994.

7. The Main Constraints. A review of Sri Lanka's economic performance suggests that the mostimportant of these policy areas are weak macroeconomic management, rigid and distorted regulatory, legal andincentive environments for private sector development, and inappropriate agricultural and financial sectorpolicies. An emerging issue is the capacity of the public sector to build a supportive institutional framework.Successive governments in Sri Lanka have tackled these constraints with halting resolve throughmacroeconomic adjustment measures and structural reforms. Since 1989, renewed efforts have led to majorimprovements in economic performance, including a sharp rise in per-capita income growth, a large increase innational, especially private, investment and savings, and a significant improvement in Sri Lanka's externalposition through accelerated export growth and an increase in private capital inflows. These exceptionalimprovements underscore both the potential for East-Asian growth levels and the need to complete the reformprogram and reverse the 1994 slippages for Sri Lanka to achieve that potential.

8. Improving Macroeconomic Management. Along with peace, macroeconomic stability is SriLanka's most urgent yet difficult task. Two macroeconomic management issues stand out in Sri Lanka. First,Sri Lanka's record on inflation is not strong, despite frequent interventions by government to moderateincreases in the prices of sensitive commodities. Inflation, as measured by the Colombo consumer price index,averaged 12% p.a. during 1980-95, with considerable fluctuations (2% - 26%). The second source of concernis the large and growing overhang of public domestic debt (about 43% of GDP at end-1994). Interestpayments have become a heavy burden on the budget, representing some 20% of central governmentexpenditures or some 6% of GDP in 1995 up from 2% of GDP in 1970.

9. Fiscal Policy. The key to achieving macroeconomic stability in Sri Lanka is to sharply reduce thebudget deficit, which directly and/or indirectly is a primary cause of inflation, rising public debt and high realinterest rates. The deteriorating debt indicators and other factors suggest the need for urgent fiscal adjustment,including negative public savings since 1988, a large primary (net of interest) deficit, and high domesticfinancing requirements in the order of 4%-6% of GDP (25 %-35 % of national savings in 1993-95), that areincompatible with moderate inflation and high growth objectives. The medium-term objective for fiscal policyis to reduce the deficit to about 5 % of GDP, followed by further consolidation to approximately 3% of GDP bythe year 2000. This deficit target is equal to approximately what can be financed by foreign concessional loansand grants and is sustainable, given inflation and growth objectives. The challenge for Sri Lanka is how toachieve these targets.

10. Raising Revenues. On the revenue side, Sri Lanka's tax effort, some 18%-20% of GDP, is onthe high side for its per-capita income, and increasing tax revenues further will mainly be a gradual process ofimproving administration. Structural measures will be mostly directed at improving the buoyancy, efficiencyand equity of the tax system rather than directly increasing revenues. The best prospects to increase revenueslie in eliminating tax waivers and exemptions, and in the non-tax area by raising cost recovery in publicservices. Given implementation constraints, rail, electricity, and petroleum products are areas where costrecovery can be increased in the short-run to be followed by irrigation, education and health.

11. Reducing Expenditures. Notwithstanding these revenue efforts, in the medium-term most of thefiscal correction will have to be achieved through expenditure rationalization. In order not to compromisesocial and growth objectives, key capital and recurrent expenditures in priority areas such as education, health,and infrastructure, including more adequate provisions for operations and maintenance, would be protected.

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Indeed, government capital expenditures have declined sharply in recent years (8% of GDP in 1995) because ofpressures to meet deficit targets in the face of rising current expenditures.

12. Hence, much of the adjustment will need to come from the current budget, especially byrestraining the wage and pension bill (8% of GDP in 1995) and, in general, improving the cost-efficiency ofthe public sector. Privatization and promoting private investment in infrastructure will reduce transfers to stateenterprises and satisfy critical needs with generally greater efficiency and without straining public resources.tUsing privatization proceeds to retire expensive domestic debt would generate indirect savings and 'fiscalspace' for human development through lower interest payments. Significant savings in welfare programs andsubsidies (3% of GDP in 1995) and more effective poverty reduction could be achieved through improvedtargeting to the poor, as described below. Defense expenditures could be cut back when peace is secured(increased from 3% in 1990 to 5% of GDP in 1995). In the short-term, the priority should be to: (i) restrainhiring, especially in the teaching corps; (ii) eliminate unproductive subsidies; and (iii) accelerate theprivatization program. Along with these measures, Sri Lanka should also consider institutional mechanismnsthat reduce the capacity of the government to adopt profligate fiscal policies. Increasing the independence ofthe Central Bank is one option that has worked well in many other countries.

13. Public Administration Reform. A reform of the civil service will be at the heart of the effortsto improve the efficiency of the public sector, and effect savings. It is also essential to build an institutionalframework supportive of well functioning markets and the private sector. Four areas are critical to the reformprocess: (a) shedding activities that could be done better by the private sector, focussing scarce public sectorcapacity to deliver quality services where markets do not work well (e.g., law and order, primary educationand health, and safety nets); (b) reinforcing the public sector's regulatory and policy functions so it can bettermanage a market economy; (c) in conjunction to the peace process, developing and implementing a coherentapproach to decentralization; and (d) discharging functions in a fully transparent manner, with clear systems ofaccountability. Political interference, feather bedding and the use of appointments for political patronage haveresulted in over-staffing, especially at lower levels, and reduced morale and effectiveness.

14. Thus, the program will include a review of the composition and management of the civil service,as well as a parallel review of the structure of government. The latter would mainly entail a re-assessment ofthe size and functions of the public administration with the view of eliminating or downsizing units withobsolete or less important functions. The main staffing implications of the reform are a reduction in numbers,a redeployment to priority functions within a redefined role of the state and to lower levels of government, andthe acquisition of new skills. Given the medium-term nature of the programme, the short-term impact is likelyto be small. Redundant staff should be compensated. When staff numbers are reduced, the compensationpackage for higher level civil servants should be made more competitive. The short-term priorities are: (a) tolimit hiring strictly, including canceling unfilled positions; and (b) to make a high profile central unitresponsible for the reform with full political backing.

15. Enhancing Accountability. Financial accounting, reporting and auditing systems are unable todayto ensure accountability in government. While the systems are considered well designed, implementationweaknesses compounded by a gradual erosion in political oversight have led to a loss of financial control. Inparticular, there are in-ordinate delays in submitting and auditing accounts, as well as in following-up onrecommendations. For example, the audits of externally financed projects are too often completed with morethan one year delay. To restore financial accountability, the immediate priorities are: (a) to insist on promptand complete financial reporting and auditing according to a code of conduct for accountants and auditors; and(b) revitalize the role of the parliamentary Public Accounts Committee. These measures would becomplemented in the medium-term by strengthening the staffing of accountants and auditors, including adequatetraining and modern automated systems.

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16. Reducing Corruption. Another government priority is reducing corruption, in part because ofrecent serious cases, such as one involving the purchase of buses for the "peoplized" bus companies. TheGovernment's initial reaction has been to strengthen the law and establish an independent investigativecommission. However, experience in other countries suggests that these initiatives work best whencomplemented by a broad range of measures strengthening institutions and dealing with the underlying causes.Such measures include reinforcing financial accountability, restoring a professional and competitively paid civilservice, and adopting more transparent procurement procedures based on competitive bidding and standardizeddocuments. Finally, trade and tax reform (limiting discretionary powers and adopting lower and more uniformrates), privatization and deregulation would reduce opportunities and incentives for corruption and promoteprivate activity and employment.

17. Promoting Private Growth and Employment. Sri Lanka's historical experience demonstratesthe importance of market friendly environment for private activity. Against the backdrop of misguided policiesin the 1960s and 1970s, the response of the economy to the reform efforts during 1980-1990 has been strong.At this point, four policy areas seem most critical: completing the reform of the trade and tax systems,addressing key structural weakness in agriculture, further financial sector reform, and improving infrastructure.In the medium-term, strengthening the legal framework is also important. Labor market issues are looked atfurther on below.

18. Trade and Tax Policy. The thrust of the Government's program in this area is to increasecompetition and eliminate distortions through tax and tariff simplification and by reducing protection. Thetrade reform program in manufacturing is far advanced and should be extended to agriculture. The short-termpriority is stabilizing the degree and nature of agricultural protection, eliminating quotas, to be followed by areduction in protection over the medium-term. Replacing the distortionary sales tax and many excise dutieswith a VAT, planned for 1996, is the priority for domestic taxes.

19. Agricultural Policies. Productivity growth in the plantation and non-plantation crop sectors hasbeen slow in Sri Lanka, and in both cases the inefficient use of land explains much of this weak performance.In 1992, management of the state plantations was transferred to the private sector through 5 year leasecontracts. However, given the long lead time and scale of the replanting and other investments required,private capital will not be forthcoming until investors are given a larger stake and longer time horizon. Outsideof plantations, agricultural potential and incomes are being impaired by restrictions in land use and ownership.Elimination of these restrictions would benefit farmers as they take advantage of more profitable opportunities.Although essential, eliminating these land restrictions will be process intensive and take time to complete.

20. Financial Sector Reform. The high cost of finance and the narrow range of financial instrumentsare important obstacles to economic expansion and diversification. Factors that lead to high interest rates arelarge public sector domestic financing requirements, an inefficient banking sector, the ethnic war, and weakfinancial savings as evidenced by the low deposit to GDP ratio. The most important action to improveefficiency in the financial sector is to privatize the two large, inefficient state owned banks which control amarket share of about 60% of both sides of the balance sheet. These banks have large losses and weakportfolios. Another area that needs attention are the regulatory and institutional deficiencies constraining thedevelopment of debt markets, in particular secondary markets for treasury securities. Reforms of immediatepriority are to review the restrictions on investments by the two state pension schemes and to allow primarydealers to hold treasury securities on their own account.

21. Improving Infrastructure. In both quality and quantity of infrastructure, Sri Lanka is behind manyof its South East Asian neighbors. These deficiencies arise from the chronic operational weakness of the publicagencies in the infrastructure sector, and from the public sector's flimsy financing capacity. To deal with theseproblems, the government is trying to attract private resources and management into the sector, through private

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ownership, BOT arrangements and partial equity sales, and to enhance the efficiency of public agencies ininfrastructure. The short-term priority is to make the arrangements for encouraging and negotiating BOO/BOTagreements more effective, especially dealing with the lack of commitment to such agreements in publicutilities and line agencies. Another priority is to proceed expeditiously with the privatization of key firms suchas Air Lanka and Sri Lanka Telecoms. International experience indicates that privatization will increaseefficiency in the delivery of these essential services and hence encourage growth. In the case of Air Lanka,privatization would help prevent losses and raise additional revenues. Completing successfully a privatizationor a BOT deal would have the extra benefit of cementing private confidence in government commitment tomarket friendly policies.

22. Strengthening the Legal Framework. The Sri Lankan legal system has several deficiencies withregard to enforcing property rights and contracts. Among the most important issues with financial or economicimplications are: (a) the weak enforcement capacity of the legal system, including long delays in resolvinglitigation in both courts and alternative dispute settlement mechanisms, poor court and property records, andweak training of judges on business and economic matters; and (b) dated laws that have not kept up withchanges in business practices and the development of new products and policy instruments, including infinancial and labor markets. While critical in the long-run, most actions to be taken in this area, includingtraining of judges, expansion of the number of courts, improvements in other dispute settlement mechanisms,and review of legislation, are of medium-term nature.

Human Development

23. Two of the Government's main objectives are to preserve Sri Lanka's edge in human developmentand ensure that the benefits of growth are shared widely, especially by the poor. To this end, the Governmentis relying on two win-win mechanisms that are not only key development objectives in their own right, butbased on international experience are also critical for long-run growth and equity. While these mechanismsvaried from country to country, they emphasize increasing opportunities for up-ward mobility and targetedpoverty programs, rather than, for example, across the board commodity subsidies. First, a key win-winmechanism is to ensure wide access to basic education and to essential health services. The second mechanismis to maximize the employment creating impact of growth. The Government is complementing thesemechanisms with a thorough review of its safety net programs.

24. Human Capital - Capitalizing on Past Efforts. Given its excellent achievements in this area,the challenge Sri Lanka faces is to maintain and further develop human resources, and complement thequantitative successes with quality improvements that a modernizing economy will require. In both health andeducation, the overall resource constraints are severe in the short-term, and the emphasis is more on usingresources effectively.

25. Education. Several indicators, including weak examination results and complaints by employerson the qualifications of applicants, suggest that improving quality in the education system is a key priority.Another issue is the capacity of university system to satisfy growing demand for higher education and forproducing practically oriented graduates trained for jobs in private business. To improve quality in primaryand secondary schooling, the priority action is to stop massive recruitment of untrained graduates as teachers.The emphasis rather should be on training of teachers, on initiating a rational teacher deployment policy, andproviding quality education inputs. At the university level, the priority is to give the system a more practicalorientation and to introduce cost recovery in a gradual manner to raise additional resources, while ensuring thatlow income students continue to have access to higher education. At all levels, a stronger emphasis on Englishtraining is essential for a society with a growing technological and international orientation.

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26. Health. Overall, Sri Lanka has good and well functioning public health services with widecoverage. The main issues are chronic child malnutrition, a resurgence of malaria, and overcrowded tertiaryfacilities. Reallocating public expenditures from tertiary services to primary facilities and to preventive healthis the priority action in health, helping to resolve both the overcrowding and malaria issues. The overcrowdingat tertiary level partly reflects the decline in quality in primary facilities that resulted from decreased allocationsof money and drugs. With regard to malnutrition, information campaigns on appropriate feeding practicesduring weaning would have the greatest impact.

27. Reducing Unemployment. Increasing job opportunities, especially for the young, is very high onthe Government's social and economic agenda. First, as noted above, a well functioning labor market iscritical for poverty alleviation. In addition, open unemployment, about 12% in 1995, is high and a significantsource of social tension. Youth violence and discontent has been a serious recurring political and socialproblem in Sri Lanka, as evidenced by the JVP uprisings. However, reducing unemployment while at thesame time providing jobs to new entrants to the labor force will require both strong economic growth andhighly flexible labor markets.

28. The Structure of Labor Markets. Sri Lanka's labor markets are divided into a protected orprivileged sector, a less regulated sector and the state plantations. The protected sector, about 25% of theemployed workforce, consists of the civil service, and employees of public enterprises and some large andmedium-scale private enterprises. Employees in this sector receive numerous wage and non-wage benefits thatare set or regulated by the government, including wages generally above those prevalent in the less regulatedsector, participation in generous pension schemes, long holidays, and an enhanced job security. In particular,the Termination of Employment Workmen Act (TEWA) prevents employers from laying-off workers for non-disciplinary reasons, including downsizing for financial reasons, without, in practice, the agreement of theworkers themselves. Hence, these rules usually oblige firms to offer large settlements.

29. Policy Options to Reduce Unemployment. These benefits motivate long-lasting search for jobs inthe privileged sector by the young and well educated, who constitute some two thirds of the unemployed.Hence, measures that reduce differences in the labor market will reduce unemployment. Two measures are oftop priority: (a) stop massive hiring into government that encourages workers to wait for government jobsrather than accept offers in the less regulated sector; and (b) amend the TEWA to reduce labor restructuringcosts for enterprises in financial distress. Such an amendment would probably increase turnover but wouldreduce labor costs and boost employment overall, and would, by providing easier entry into the job market,reduce youth frustration. To help the poor and less educated, an option is to expand public expenditures inhigh return labor intensive areas (e.g., road maintenance) as part of a well targeted safety net program. Thereis in addition a need to bring employers and workers into a partnership with the Government to foster growthand employment.

30. Targeting Safety Nets. Because of ineffective targeting, Sri Lanka's safety net programs transferrelatively modest sums to a large fraction of the population rather than adequate sums to the very poor. Theyare a significant budgetary burden: the estimated annual cost of the transfer programs and the flour andfertilizer subsidies is around 3.5% of GDP. However, the real value of transfer levels to the pooresthouseholds are not as high as they should be.

31. Recent Initiatives. Sri Lanka has improved targeting of these programs over the past 15 years.The Government intends to consolidate the food stamp, mid-day meal and main Janasaviya programs into anew and better targeted program called Samurdhi. Samurdhi is intended to benefit some 1.2 millionhouseholds (about 30%) compared to the 1.5-1.6 million receiving food stamps and the untargeted mid-daymeal. Samurdhi participants will receive a monthly transfer of Rs. 500 (the extreme poor Rs. 1000), asignificant increase. The net effect will be to raise the poor above the minimum poverty threshold. However,

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there have also been serious setbacks. In particular, two new commodity subsidies, on wheat flour andfertilizer, were introduced in 1994 that are not targeted. Indeed, the flour subsidy is very regressive. Basedon the 1990/91 household expenditure survey, the 20% richest households will receive about 32% of thesubsidy while the poorest 20% receive only 9%.

32. Improving Targeting. The priority measure in this area is to eliminate as quickly as possible theregressive wheat flour subsidy as well as the fertilizer subsidy. The Government could consider increasingSamurdhi benefits by some Rs. 400 million (the estimated value of the flour subsidy going to the poor), toensure that real incomes of the poor do not suffer. Important but of less priority is to eliminate "interestpayments" of Janasaviya, now received by some 400 thousand beneficiaries. While maintaining constant thetotal number of households at 1.2 million, Janasaviya households should be screened and incorporated intoSamurdhi. Other untargeted programs (e.g., free school uniforms) should be discontinued.

33. Winners and Losers. Identifying short-term winners and losers helps the Government assess theneed for mitigating measures. In the long-term, the Government is confident that the combination of highersustained growth, wide access to good quality social services and a decline in the unemployment rate shouldincrease living standards across the board.

34. The Poor. The poor, basically those households in the lowest three income deciles', will be netbeneficiaries from the reform program. Fundamentally, better targeting of the safety net programs will resultin a significant increase in transfer levels. Based on data from the 1990/91 expenditure survey, the averageincome of households in the first decile would increase by about 21 % (in 1994 prices) with a transfer of Rs.500/month. In addition, the decline in prices of essential foodstuffs resulting from the gradual reduction inprotection would also benefit the poor. This result holds true even for rice since, according to the samesurvey, about 90% of households in the two lowest deciles are net consumers of rice. Increased expenditureson roads and other labor intensive activities, in particular for operation and maintenance, should increase thedemand for unskilled labor. Despite this overall positive evaluation, some important caveats apply to protectthe poor fully. Basic education and health should be protected from cuts, while cost recovery should be carriedout with due regard for the poor, for example, by needs based scholarship programs or electricity life lines.

35. Overall, plantation labor, among the poorest groups, will likely also benefit in the short-term fromthe program. One problem is that, at current output levels, the demand for additional worker in someplantations is estimated to be less than the labor surplus in others. However, the proposed reforms, byattracting capital to the sector, would be beneficial to workers as employment opportunities and productivitygrow. In addition, as in other privatization transactions, the Government will transfer a 10% equity share ofthe management companies to workers. In addition to being pro-poor, this has the benefit of demonstrating ina tangible manner how minorities can share in the benefits of development.

36. The Middle Class. The net impact on middle income groups of the non-budgetary measures ofthe reform program is likely to be positive. Based on past experience, it is likely that the privatizationprogram will not lead to significant job losses. The increase in labor demand derived from the outputexpansion that could accompany privatization and private investment could more than compensate for existingoverstaffing. In addition, the proposed labor market reforms will be particularly positive for the relativelyeducated. However, some short-term losses can be expected as a result of the civil service reform, and therestructuring and targeting of social sector programmes (including education) to benefit the poor. In addition,further research on the distributional impact of the proposed cost recovery measures would help assess the needfor mitigating measures, although increases in the more sensitive areas will likely be gradual.

I Each decile represents an income group composed of 10% of the population.

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Sri Lanka: Agenda for Year 2000.

Area Short-Term Medium-Term ReasonsMeasures Measures

L POLICIES TOSTRENGTHENSUSTAINABLEGROWTH

1. Government Expenditure: Increase public savings andBudEet - Strictly limit hiring into public sector. - Implement civil service reform. reduce fiscal deficit, in order

to make adequate savingsavailable to the privatesector. Improve efficiency ofpublic expenditures.

- Eliminate commodity subsidies.- Use privatization proceeds for

retirement of debt.- Implement reform of govenmmentpension system.

- Increase expenditures for operation andmaintenance in key sectors.

Revenue: Increase public savings and- Increase cost-recovery in rail, - Increase cost-recovery for other public reduce public sector deficit.

electricity, and petroleum products. services such as higher education, Increase efficiency inhealth, irrigation, water, and resource allocation.telecomunications.

- Eliminate tax exemptions andconcessions.- Introduce PSI. - Improve tax administration. Increase

direct tax revenue.

2. Exchange Rate - Maintain a stable and competitive - Maintain a stable and competitive Maintain extemalPolcv. exchange rate. exchange rate. competitiveness.

3. Public - Limit new hiring and cancel unfilled - Implement civil service refomm . Improve the effectivenessAdministration positions. and efficiency of the publicReform sector. Effect savings.

- Establish oversight mechanisms forimplementing civil service reform.- Institutionalize prompt and complete - Improve staffing and training of Improve accountability and

financial reporting and auditing. accountants and auditors. reduce corruption inGovemment.

- Revitalize the role of the parliamentaryPublic Accounts Committee.

- Adopt transparent and streamlinedprocurement procedures based oncompetitive bidding and standardizeddocuments.

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4. Trade and Tax Increase competition andReform External: - Adopt a uniform tariff of 15 percent eliminate distortions through

by 1998 in manufacturing. tax and tariff simplifications.- Adopt more stable protection level and - Reduce protection in agriculture,system in agriculture. Eliminate including for paddy, eliminating anti-quantitative restrictions. export bias.Internal:- Replace sales tax and excise duties - Continue to rationalize tax

with a revenue-neutral VAT. concessions granted by BOI and movetoward moderate direct tax regime.

5. Financial Sector - Begin to privatize Bank of Ceylon. - Complete Bank of Ceylon and Improve efficiency ofReform privatize Peoples Bank. financial intermediation and

promote private savings.- Review restrictions on investments by - Establish auctions of medium- and

the Employees Provident Fund and long-term govemment debt.Employees Trust Fund.- Allow primary dealers to hold treasury - Encourage establishment of rating

securities on their own account. agencies.- Further open the capital account,including:

(a) Institute more automaticmechanisms to authorize firms andbanks to raise capital in internationaldebt markets.

(b) Review the appropriateness ofcurrent prudential ratios, and reinforcethe supervision of financial system.

6. Legal Reform - Revitalize Law Reform Commission. - Strengthen enforcement capacity of Improve institutionallegal system by improving quality and framework for privateefficiency of courts, altemative dispute activity.settlement mechanisms and institutionssuch as property and companyregistrars.- Review legal system includingcompleting ongoing reform of theCompanies Act, followed by labor laws,bankruptcy laws, etc.

7. Aericulture Plantations: Increase productivity in the- Implement longer term land leases. agricultural sector.- Privatize the plantation companies.- Stop govermment interference incollective bargaining.

Non-plantations:- Eliminate restrictions on land use and

ownership.- Regularize land titles.- Eliminate monopoly power of CWE,

especially wheat marketing.- Free up input, (e.g. fertilizer ) andoutput (e.g. rice) marketing, includingprivate sector participation of CFC andPMB.

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& Infrastructure - Increase commitment to BOO/BOT in - Review roles of line and special Attract private resources anpublic utilities and line agencies. agencies to attract private investment. management into the sector- Begin privatization program, starting - Expand privatization efforts,

with Air Lanka. especially to telecom and power.- Resolve regulatory issues to manage

private provision of services.- Set-up long-term debt fund to

supplement private debt and equitycapital.

HUMANDEVELOPMENT

9. Labor Market - Stop massive hiring into government - Amend TEWA and other labor laws. Reduce unemployment and(see above). increase flexibility in the

labor markets.- Expand public expenditures in high-

return and labor intensive activities suchas O&M and rehabilitation of roads (seeabove).

10. Education - Stop massive recruitment of untrained - Train the large number of untrained Improve quality in educatio:graduates as teachers. Implement teachers and provide quality education services.teacher deployment program. inputs.

- Give the university system a moredemand orientation.- Introduce cost-recovery in higher

education.

11. Health - Carry-out information campaign on Reduce malnutrition.appropriate feeding practices duringweaning period.

- Reallocate public expenditure from - Introduce cost-recovery in tertiary Improve public health.tertiary to primary facilities, and care.preventive care.

- Formulate a policy on the division oflabor between the public and privatesector.

- Begin implementation of anti-malariacampaign.

12. Social Safety Net - Consolidate "interest payments" of - Improve screening techniques. Enhance the effectiveness olJanasaviya into a new better targeted the social transfer programsprogram (Samurdhi). in supporting the poor.- Eliminate wheat and fertilizer

subsidies.

SRI LANKA IN THE YEAR 2000AN AGENDA FOR ACTION

I. Introduction

1. The newly elected Government in Sri Lanka has high hopes that during its 6-year mandate(ending in the year 2000) it can significantly improve the quality of life of every Sri Lankan. It has avision of a peaceful, prosperous and just Sri Lanka, in which all, irrespective of ethnic origin, religion orincome status, are working together to raise individual and collective prosperity. An essential element ofthis vision is a rapid and sustained increase in economic activity to provide the jobs and opportunities toeradicate poverty and promote human development. In a sense, the Government's vision is that of a moregentle and caring East Asia, in which the rapid economic growth of the East Asia experience is combinedwith the traditional emphasis of the Sri Lankan policy on poverty alleviation and human development.

2. Indeed, Sri Lanka's greatest asset to achieve this vision is its remarkable success in humandevelopment. The level of social development is ahead of other countries at similar and even higher per-capita income levels. For example, Sri Lanka has better indicators of life expectancy, infant mortality,adult literacy, and secondary school enrollment that Indonesia and Malaysia, two of the more dynamiccountries of South-East Asia. This success is the result of continued investment in health and educationthat have sharply improved already good initial social indicators. The challenge is to maintain and advanceSri Lanka's edge in human development.

3. There can be no doubt that achieving lasting peace is essential for this vision. It is the singlemost important challenge faced by the Government. Without peace, whole regions of the country andmany members of the Tamil community will not be able to share in the benefits of development. Andwithout peace, it is doubtful that Sri Lanka will be able to emulate its more successful Asian neighbors interms of economic growth. The Government has rightly placed peace first in its agenda and has takencourageous steps to end the war, opening negotiations with the LTTE. While the recent renewal ofhostilities is a terrible blow, the Government remains committed even today to a negotiated settlement.

4. Another key challenge faced by the new Government is improving Sri Lanka's long-termgrowth performance. During 1961-93, Sri Lanka's per-capita GDP has expanded at an average annual rateof 2.8%, approximately the same as the average growth rate for the low income economies during 1965-90.While this performance is good, it is below potential, especially taking into account Sri Lanka's wealth ofhuman capital. With a per-capita income of about US$ 600, Sri Lanka remains a low income countrysome 50 years after Independence. The World Bank's Poverty Assessment' estimates that one out of fiveSri Lankans was poor in 1990, when measured against a consumption poverty line close to the "one-dollar-a-day" absolute poverty benchmark.2 These numbers are in sharp contrast to the social indicators.

5. Given excellent human resource indicators, and the traditional generous public and privatesafety nets, growth is the weak link in Sri Lanka's poverty alleviation strategy. Other factors remainingequal, a stronger growth performance comparable to that of the more successful Asian economies wouldhave led to deeper reductions in poverty. It is increasingly recognized in Sri Lanka that poverty is not alocalized phenomenon, and that lasting and rapid declines in poverty require broad based, high andsustained growth based on the private sector. This is the only realistic way to create more and betterpaying jobs, and to increase income and consumption for the majority of the poor.

I World Bank, Sri Lanka - Poverty Assessment, (1995).

2 Per-person in 1985 purchasing power parity.

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6. Another concern of the new Government is that indeed the benefits of growth are sharedwidely, in particular by raising employment and preserving Sri Lanka's edge in human development. Theexperience of other Asian countries demonstrates that all income groups, including the poor, can benefitfrom rapid private sector led growth (Box 1), if the policy framework is appropriate. According to thePoverty Assessment, in Sri Lanka income distribution in 1990 was roughly the same as that of the early1950s, implying that the tripling in real per-capita consumption during this time period has been shared byall income groups. The emphasis on human development cannot be unrelated to this favorable result.

Box 1:Econonmc Adjustment, Growth and Income Inequality

Some analysts believe that while the process of economic liberalization and adjustment can result in rapideconomic growth, it brings little benefit to the poor because of the negative impacts of such policies on incomedistribution. However, there are many examples of developing countries that suggest otherwise, that rapid privatesector led growth is compatible with relatively lower levels of income inequality.

The experience of the dynamic Asian Economies (Hong Kong, Indonesia. Korea, Malaysia, Singapore,Taiwan [China] and Thailand) is particularly relevant in this regard. They have achieved unusually low anddeclining levels of inequality and high per-capita growth rates. In particular, in these countries:

Income inequality (as measured by the ratio of the income shares of the richest 20% and the poorest20% of the population) is among the lowest of developing nations. The East-Asia Miracle study ranksforty countries by the income inequality ratio and per-capita GDP growth during 1965-89. Of theseforty, only the seven countries mentioned above had low inequality ratios (below 10, in the samerange as OECD economies) and per-capita growth rates above 4% p.a.. While most South-Asianeconomies, including Sri Lanka, had low income inequality ratios, growth performance has not beennearly as strong.

Income distribution (as measured by Gini coefficients) has improved between the 1960's and1980's. In fact, according to the East-Asia Miracle study, improvements in income distribution inthe dynamic Asian economies generally coincided with periods of rapid growth.

These favorable outcomes were partly the result of policies and initiatives to increase opportunities for allto share in the benefits of growth. While these mechanisms varied from country to country, in these sevencountries they emphasized increasing opportunities for upward mobility rather than granting direct income transfersor subsidizing specific commodities. The mechanisms/policies included wide access to primary and secondaryeducation, land reforms, support for small and medium-scale industries and public support for low-income housing.In addition, where relevant, these countries adopted policies favorable to agriculture, leading to rapid increases inagricultural productivity and rural wages and incomes. raising living standards in rural areas where initially themajority of the population resided.

Source: World Bank, The East-Asian Miracle (1993).

7. The purpose of this paper is to elaborate a medium-term policy framework to achieve theGovernment's development objectives in an effective and sustainable manner. It is based on the twoeconomic policy statements of the Government3, but attempts to more concretely explain mechanisms andpolicies to achieve the Government's goals in important selected areas. It focuses first on a set of policiesto address how to raise the growth rate (section 11), including: (a) strengthening macroeconomicmanagement, (b) promoting private activity through improvements in the incentive and legal frameworks,and by policy reforms in agriculture, the financial sector, and infrastructure; and (c) raising the efficiency

Economic Policy Statement of the Government of Sri Lanka, by the Hon. Chandrika Bandaranaike Kumaratunga,Prime Minister of Sri Lanka, Colombo, Sri Lanka, September 13, 1994. Policy Statement of the Government of SriLanka on the Occasion of the Opening of Parliament, by H.E. Chandrika Bandaranaike Kumaratunga, President of SriLanka. Colombo, Sri Lanka, January 6. 1995.

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and implementing capacity of the public sector. The paper then turns to policies to further advance humandevelopment in Sri Lanka and ensure widespread distribution of the benefits of growth. In particular, itlooks at how to increase employment (section 111), how to improve the quality and productivity of basicsocial services (section IV), and how to improve the targeting and cost effectiveness of the povertyprograms (section V).

II. Achieving Sustained, Rapid Growth

A. Promoting Growth -- International Experience and Lessons from the Past

8. In order to eradicate poverty and unemployment, a fundamental objective of the Governmentis to increase the rate of income growth in a sustainable manner. Despite similar initial conditions. SriLanka's long-run performance has been much weaker than the high performing Asian economies. Forexample, while real GDP p.c. increased in Sri Lanka by 2.8% p.a. on average during 1961-93 (Table 1), itincreased by 3.4% p.a. in Indonesia, 6.5% p.a. in Korea, 4.2% p.a. in Malaysia and 5.2% p.a. in Thailand,on average during 1960-92. Agricultural growth has been particularly low in Sri Lanka, about 2.8% p.a.on average during 1961-93 compared to 3.5% and 4.4% in Indonesia and Thailand, respectively, during1978-92. While Sri Lanka emphasized education and health like the more successful of its Asia neighbors,it was not able to exploit fully its human resource base to increase income as rapidly.4

9. Underlying Sri Lanka's lower growth rates lie other weaknesses in economic performance.First, while Sri Lanka invested on average about 20% of GDP during 1961-93, the more dynamic East-Asian countries in contrast invested some 32% of GDP during 1978-92. The latter were able to sustain thisrapid accumulation process through high domestic savings rates, while in Sri Lanka the savings effort hasbeen lower (only in 1993 did national savings surpass 20% of GDP). Furthermore, investment productivityin Sri Lanka has also been lower: on average, returns on capital during 1960-90 were about 21% comparedto 26%-33% in Indonesia, Korea, Malaysia and Thailand.s Another contrasting indicator is Sri Lanka'slong-run export performance, which despite recent improvements, has been poor (3.2% p.a. in constantprices between 1961-93).

10. These results largely reflect policy problems in a number of critical areas, compounded in the1980's by ethnic and civil strife.6 Among the most important of these problems is weak macroeconomicmanagement, in particular a chronic high fiscal deficit, resulting in inflation and crowding out of privateinvestment. The cost of the war added to the budgetary imbalance. An overvalued exchange rate has beenthe other chronic macroeconomic policy problem, impeding the development of a competitive export sectorand reducing growth. Second, the incentive and regulatory environments are also critical policy issues, andwere especially constraining in the past. Investment regulations and prohibitions and foreign exchangerestrictions stifled private investment, while high trade barriers protected inefficient activities and inhibitedexports. The corollary of this is that the State's role is very wide in Sri Lanka. including areas where ithas little comparative advantage, with negative effects on costs and efficiency, for example, in the State-

4 For a comparison of the initial conditions in Sri Lanka and East Asia, see S. Ahmed and P. Ranjan (1994).

5 S. Ahmed and P. Ranjan (1994).

6 The severity of extemal shocks is not a major factor explaining Sri Lanka's weaker growth performance. Theseshocks were about the same in Sri Lanka as those undergone by successful oil importers such as Korea and Thailand.see I.M.D. Little, R. Cooper, W.M. Corden and S. Rajapatirana (1994).

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owned plantations. Agricultural growth has also been affected by inappropriate land and price policies.Third, financial sector policies have hampered both efficient intermediation and resource mobilization.'

11. The Benefits of Peace. It is difficult to overstress the negative consequences of the civil waron Sri Lanka's economic performance. Most obvious are the terrible human suffering and loss of life andthe destruction of large parts of the North and East, including social and economic infrastructure. The civilwar has also severely reduced private confidence and investment. It has increased the budgetary defenceburden by some 3 points to 4%-5% of GDP in the 1980's and 1990's, increasing public financingrequirements. The war has also led to a loss of human capital through emigration. On the external side,tourism receipts have remained depressed, and only in 1994 did the number of tourists attain the levelsreached in the early 1980's. With peace, as confidence is fully restored over the medium-term, privateinvestment will increase, as will tourism. As the potential of the North and East is restored, and fullyreintegrated into the national economy, peace will set the stage for an economic boom if the process is wellmanaged. This includes tackling the macro-issues, as well as undertaking the structural reforms required toboost growth.

Table 1: Adjustment and Growth in Sri Lanka

Sri Lanka East Asiab'

1961-93 1971-77 1978-82 1983-89 1990-93 1978-92

Growth IndicatorsGDP p.c. (% change p.a.) 2.8 2.5 4.4 2.1 4.3 NA

GDP (% change p.a.) 4.6 4.0 6.1 3.6 5.4 7.3Agriculture (% change p.a.) 2.8 2.0 4.0 1.5 3.3 NAIndustry (% change p.a.) 5.1 1.0 6.9 4.6 7.2 10.3Services (% change p.a.) 4.9 5.2 7.4 4.2 5.5 7.9

Savings/Investment IndicatorsGDI (% of GDP) 20.0 16.2 27.5 23.9 23.6 31.6GNS (% of GDP) 14.8a/ 12.9 14.7 15.7 17.5 NAGDS (% of GDP) 12.7 13.1 12.7 13.4 14.2 32.8

Extemnal IndicatorsExports (% change p.a.) 3.2 -1.7 8.2 2.1 12.3 10.5Imports (% change p.a.) 2.9 -2.4 15.7 -0.1 10.7 11.0Current Account Balance(% of GDP) -7.2a' -3.3 -12.8 -8.2 -6.1 -0.3

Note: a/ 1970-93.b/ Defined as Hong Kong, Korea, Singapore, Thailand. and Taiwan, China.

Source: The World Bank, International Economics Department.

12. Past Adiustment Efforts. In an attempt to boost growth, successive governments in Sri Lankahave implemented both macroeconomic adjustment measures and structural reforms. The reform effortstarted in 1978, when barriers to external trade were reduced and many of the most onerous controls onprivate sector activity were abolished. However, this first reform effort faltered in 1982 as the Governmentfailed to reduce the fiscal and external deficits and the size and scope of the public sector, and more

S. Ahmed and P. Ranjan (1994) provide evidence of the importance of these policy factors. Through an econometrictime series model, they found that weak macroeconomic management (as measured by the black market foreignexchange premium), govemnment consumption (a proxy for the size and efficiency of the public sector) and the civilconflict are inversely related to real GDP growth.

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importantly, as ethnic and civil strife engulfed the country. Since 1989, when political violence declined,the implementation of the adjustment program intensified once again.

13. Economic reform has had three main elements in Sri Lanka. First, economic managementwas strengthened to build a stable macroeconomic environment favorable to private investment and savings.Second, efficient private sector activity was encouraged by dismantling price, investment and foreignexchange controls, lowering import barriers and privatizing state-owned enterprises. Finally, theGovernment decreased the amount of resources directed towards productive and commercial activities withthe dual objective of reducing expenditures and providing more resources for the provision of public goodsand services. The Government also implemented measures to increase cost effectiveness in those areas toremain in the public sector's domain. The adjustment effort was most successful in the second area. Withregard to macroeconomic stability, between 1989 and 1993 there was also progress overall, although sincethe election year of 1994 budget discipline has deteriorated significantly.

14. The adjustment efforts have led to major improvements in Sri Lanka's economic performance(Table 1). During the two adjustment periods, 1978-82 and 1990-93, per-capita growth rates in Sri Lankawere almost double their long-run trend; the improvement is robust across all sectors. Other long-rungrowth indicators, such as investment/GDP and savings/GDP ratios, also strengthened considerably,auguring well for future growth and its sustainability.8 A most positive feature of the 1990-93 period isthe rapid growth in private investment from 12% of GDP in 1987 to 18% in 1993. But perhaps moststriking is the performance of the external sector. In contrast to their long-run trend, exports and importsincreased by 12.3% and 10.7% p.a. on average during 1990-93. The export boom is mainly the result ofrapid growth in the garment industry, although other non-traditional manufactured exports also areexpanding quickly, but from a small base. The export orientation of the economy has grown rapidly to34% of GDP in 1993 from 26% in 1988, as has the relative size of the manufacturing sector. Thesefavorable results provide compelling evidence of the importance of policy factors in explaining Sri Lanka'sweak performance in the past.9

15. The Government needs to persevere in the reform effort if these improvements in economicperformance are to be sustained. Of particular importance, especially in view of the fiscal slippage in1994, is ensuring macroeconomic stability. Better macroeconomic management needs to be complementedby policies promoting efficient private investment and savings, including providing the necessary economicinfrastructure, and creating efficient and secure financial systems and flexible markets with few distortions.Despite all the progress achieved, the private sector reform agenda is still very large. The size of thereform agenda raises the question of what can be done to improve the implementation capacity of thepublic sector, while reducing its cost in view of the budgetary pressures. The remainder of this chapterreviews the main outstanding issues in these three areas, starting with macroeconomic performance.

B. Improving Macroeconomic Management

16. Defining Macroeconomic Stability. Good macroeconomic management, considered criticalfor sustained growth (Box 2). is usually defined to mean that:

Inflation is kept under control - in Sri Lanka this would require reducing inflation to singledigits, close to that of its trading partners, in a sustainable manner. Sri Lanka's record oninflation since the early 1970's is not strong, despite frequent interventions by government to

This is more true for the most recent adjustment period 1990-93. During the 1978-82 episode, the rapid expansion ineconomic activity was in part driven by the building of the low return large Mahaweli irrigation scheme, and theinvestment-domestic savings gap was un-sustainable.

Improvements in the terms of trade are not a major factor in explaining the rise in the growth rate. In fact, the 1978-82 episode coincided with the second oil shock, and during 1990-93, the terms of trade remained approximatelyconstant.

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Box 2:The Benefits of Macroecononmc Stability

International expenence suggests that macroeconomic stability is critical for growth for several reasons. First,responsible macroeconomic management reduces inflation and makes it more predictable, encouraging long-termplanning, private investment and financial savings. Inflation is also potentially very hannful for the welfare of thepoor since they have few financial reserves to draw upon if their incomes increase less than prices. Second, prudentpublic domestic borrowing leads to lower interest rates and does not crowd out private borrowing. hence favoringprivate investment. In addition, prudent macroeconomic policies strengthen private sector confidence, both domesticand foreign, once again favoring private investment. Macroeconomic stability also favors export growth by reducinginflation differentials with trading partners and facilitating extemal competitiveness. Finally, strong exportperformance coupled with cautious foreign borrowing will strengthen creditworthiness and ensure that externalobligations can be met without sudden reductions in consumption and investment so hannfui to growth and economicwelfare. The experience of East Asia proves that these benefits are not just theoretical. These countries have achievedlower inflation rates, higher savings and investment rates, more stable real interest rates, less appreciated and morestable real exchange rates, more favorable debt to export ratios, and of course, much higher per-capita growth ratesthan most other developing countries.

There is also substantial empirical evidence that a stable macroeconomic environment, meaning low and stableinflation, small budget deficits and an undistorted foreign exchange market, is conducive to growth. The positiveimpact on growth has been found to work through two channels: good macroeconomic policies lead to higherinvestment as well as to greater productivity growth. For example, S. Fischer found that the 10% point increase ininflation would reduce the rate of growth of capital by almost one-half of a percentage point.

Source: World Bank: The East-Asian Miracle (1993) and S. Fisher (1993).

moderate increases in the prices of sensitive commodities. For example, not only was theaverage annual inflation rate (CPI) during the period 1980-91 relatively high, about 12%, italso fluctuated considerably during both the 1970's and 1980's. The comparison with theEast-Asia countries is unfavorable which during the same period attained single-digit andstable inflation rates. Since August 1994, inflation has declined to single digits in Sri Lanka,but primarily by reducing administered prices, in some cases resulting in large subsidies (e.g.,wheat).Public internal debt and external debt remain manageable - in Sri Lanka the main sourceof concern is the large overhang of public domestic debt (about 43% of GDP at end 1994)which has resulted in a large and rising interest burden for the budget (about 20% of currentexpenditures). While the stock of external debt is high (52% of GDP at end 1994), SriLanka benefits from concessional sources of financing. These obligations should not be amajor cause for concern if external borrowing policies remain prudent and exportperformance satisfactory; andPolicies are flexible, quickly responding to changing economic circumstances - in SriLanka, the little room to adjust public expenditures in the event of an unanticipated economicshock is of serious concern. The budget is dominated by interest payments, the wage bill anddefense, all difficult to compress.

17. Large Budget Deficits and Overvalued Exchange Rates: Two Chronic Macroeconomic Issues.The key to achieving macroeconomic stability is prudent fiscal policy. High fiscal deficits increaseaggregate demand resulting in inflationary pressures and higher external current account deficits. Inaddition, international evidence suggests that large fiscal deficits are probably the primary cause ofmacroeconomic instability in most countries. Excessive monetary financing leads to inflation, whileexcessive domestic borrowing drives up interest rates and crowds out private borrowing, and immoderateforeign borrowing leads to debt crises and loss of creditworthiness. Sri Lanka's record in this area is weak.For example, the average fiscal deficit during 1980-88 was high (14% of GDP), and contributedsignificantly to the rapid growth in domestic and international indebtedness, as well as to inflation. In

contrast, fiscal deficits during this period in the East Asia countries were significantly smaller, and theirfinancing had small negative macroeconomic consequences. The progress achieved in Sri Lanka during1989-93 in reducing the fiscal deficit from 11.2% of GDP to 8% was encouraging, but the slippages andnew spending initiatives undertaken in 1994 associated witih the elections, have led to a sharp reversal to9.7%. In 1995. the fiscal deficit is estimated to worsen somewhat at a ratio to GDP at 10.3% because ofrising defence expenditures and slow progress in correctintg the 1994 slippages.

18. Another important element of good macroeconiomic policy, especially for a small, nowoutward looking economy like Sri Lanka, is mainltaininig a stable and competitive real exchange rate.International experience, including that of East Asia. demonstrates its importance for export promotion andsustaining trade liberalization. Maintainin,, a competitive real exchiange rate requires not only flexibleexchange rate management that takes into account chaniges in the structure of protection, but also prudentfiscal and monetary policies. In Sri Lanka. the maniagement of the exchiange rate improved in 1980's withthe unification of the exchange rate and the adoption of a managed float type mechanism. However. sincethe devaluation of 1978. the real exchange rate hlas shiowvn an appreciating trend, in part because of largegovernment spendinig and capital inflowvs, especially official aid.'° Both official aid and private capitalflows need to be managed carefully to avoid real exchange rate appreciation, a decline in the fiscal deficitand, especially, government expenditures would help considerably. since public expenditures have a highcontent in non-tradeable goods.

19. Fiscal policy: Obiectives and instruments. While the level of the fiscal deficit consistent withmacroeconomic stability depends on the circumstances of each economy, there are several indicators thatsuggest that further fiscal adjustment is required in Sri Lanka:

- Public savings have been negative since 1988. This implies that Sri Lanka has beenborrowing to fund government consumption including defense, transfers and subsidies andother expenditures with low economic rates of return.

* Domestic financing requirements remain high despite adjustment efforts of the early1990s." While the Government has not resorted to monetary financing during 1992-93, thedeficit, through its direct impact on aggregate demand, has been a major contributing factorto inflationary pressures. In addition, crowding out of private investment is of seriousconcern. Budgetary domestic financing requirements in 1993 represented some 4.5% of GDPor 25% of gross national savings and were an important contributor to the high real interestrates during 1992 and 1993. In 1994, domestic financing of the budget rose to 6.6% of GDP,or 35% of national savings, with no improvement expected in 1995. In Sri Lanka, crowdingout also works through mechanisms such as the public sector's control over importantsources of long-term capital such as pension funds, savings banks and insurance.

* Sri Lanka since 1960 has been incurring a large primary deficit, defined as the fiscaldeficit net of interest obligations on public debt [Figure 1]; on average, it amounted to 3.2%of GDP between 1990-94. The primary fiscal balance can also be defined as the amount ofresources available to service interest.'2 Hence, a large primary deficit implies that the

'° S. Ahmed and P. Ranian (1994). See also H. White and G. Wignaraja (1992).

The sharp contraction in the fiscal deficit between 1988 and 1993 from 15.7% of GDP to 8% was the result ot areduction in capital expenditures, in particular with the completion of the gigantic Mahaweli scheme. As could beexpected, foreign financing of the deficit also declined, but to a lesser extent, from 6.2% of GDP in net terms in1988 to 3.6% of GDP in 1993.

12 A primary deficit (after grants) usually implies an increase in the debt/GDP ratio. However, even if the primary

balance was zero, the debt/GDP ratio would increase if the real GDP growth rate is lower than the real interest rateon public debt because the increase in the numerator (interest being capitalized) would be larger than the increase inthe denominator (increase in real GDP). In Sri Lanka, the favorable terms on external debt and the high growthrates during 1990-93 favorably affected the debt dynamics.

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Hence, a large primary deficit implies that the Governmenit is borrowing not only to financeoperational expenditures. but also to be able to pay interest on past debt.The long-term trends in key debt indicators, in particular the debt/GDP and theinterest/GDP ratios, are of serious concern. Between 1980 and 1994, the total debt/GDPratio has risen from 70% to 95%, and interest payments as a ratio to GDP from 3.4% to6.4%. In fact, the interest burden has been rising inexorably since 1960 [Figure I], and by1992 had become larger than the cost of the war.

Figure 1: Fiscal Sustainability

Rising Interest Payments Large Primarv Deficit7 6

6 5

5~~~~~~~~~~~~~

0 0Lr CY) r - LzeO N m tU

rl- r- co 0) a) ~~~~0 () 0) 03)(31 a, 01 0) im m~~~~~~0 0)

Source: Central Bank. Source: Central Bank.

20. The medium-term objective for fiscal policy is to reduce the fiscal deficit to about 5% ofGDP, followed by further consolidation to approximately 3% of GDP by the year 2000, approximatelyequal to the amount that can be financed with external grants and concessional loans. While more analysisis needed, the logic behind these targets is as follows. A deficit target should be consistent with theGovernment's objectives to reduce inflation, increase growth and decrease the debt/GDP ratios. Hence,given the already high domestic debt/GDP ratio and the heavy interest burden, it would be prudent toreduce domestic borrowing sharply and, in the longer-term, even eliminate any new net domesticborrowing. This would also be beneficial for growth by reducing pressures on domestic interest rates andcrowding out of private investment. Second, the Government has already prudently discarded the use ofmonetary financing of the deficit to reduce inflation, especially in view of inflationary pressures resultingfrom foreign private capital inflows (Box 3). Hence, the only sustainable medium-term source of deficitfinancing is external concessional funding. The current level of these flows seem consistent both withexternal solvency and the need for an increasing proportion of foreign savings to be channelled to theprivate sector.

21. It will be a major challenge for Sri Lanka to achieve these targets. The magnitude of thefiscal effort required is very large, in the order of 6% of GDP in the medium-term (8% in the long-term),if the underlying deficit before measures is around 11% of GDP in 1995. The options available aredifficult. First, while there is some room to increase revenues, especially in the non-tax area, Sri Lanka'stax effort (18% of GDP) is satisfactory considering its per-capita income level. Hence, most of the fiscalcorrection will need to be achieved through cuts in public spending. In this regard, there is little fat in thecapital budget which has been on a downward trend since 1988. In contrast, the Government's efforts tocontain current expenditures have had limited success. Little progress was achieved in limiting wage and

significant burden (about 5% of GDP). In 1994, current expenditures increased by some 2 points of GDPto 22% of GDP and remained about that level in 1995. Hence, most savings will need to be found incurrent expenditures.'3 Given that excessive fiscal deficits and inflation are a chronic problem, Sri Lankashould also explore adopting institutional mechanisms, such as increased Central Bank autonomy, that limitthe Government's ability to depart from responsible fiscal management (Box 4).

Box 3:Capital Flows and Macroeconomic Policy

Sri Lanka has been rapidly opening its economy to the rest of the world by reducing trade barriers,including foreign exchange restrictions. Sri Lanka achieved Article Vill status in the IMF in March 1994 when therupee became fully convertible for all current account transactions. In order to attract foreign direct and portfolioinvestment, Sri Lanka has also eliminated restrictions on profit and dividend repatriation. Current accountconvertibility has also diminished the effectiveness of the remaining capital controls.

This de-facto partial opening of the capital account has two important implications for economic policy.First, it has become increasing difficult for domestic interest rates, subject to a country risk premium andexpectations of exchange rate changes, to depart for long and by much from intemational rates. For example, lowdomestic interest rates resulting from an expansionary monetary policy will create incentives for capital to seekhigher retums overseas and, as reserves contract, put upward pressure on domestic interest rates. This means thatmonetary policy has lost effectiveness in influencing domestic interest rates which will tend to be determined byintemational rates (unless the exchange rate is fully flexible). Econometric evidence indicates that a one pointincrease in foreign interest rates, all else remaining equal, will lead to a 35 basis point increase in domestic rateswithin one quarter. As expected, the evidence also shows that the influence of foreign interest rates has increasedin recent years. Second, an open capital account acts as a check on policy makers to pursue prudent economicpolicies since divergence from this course will show up quickly in capital outflows and reserve loss difficult tosustain for an extended period.

This loss of control has generated debate in Sri Lanka over what are the respective roles for monetary,fiscal and exchange rate policy in this new setting of a more open capital account with a managed exchange rate.However, both theory and the experience of other countries, for example, Indonesia (which has performed wellwith an open capital account), suggest that the implications are less threatening than is apparent. Monetary policycontinues to have an essential role in supporting the balance of payments by protecting reserves and in maintainingprice stability. Its objective would be to ensure that money supply expands in line with demand by adjustingdomestic credit to compensate for changes in international reserves. Fiscal policy should be determined by longer-run growth and social objectives, but must also be well coordinated with monetary policy, in particular with theobjective of keeping domestic inflation in line with the world inflation. In the face of a surge in capital inflows,the control of the money supply would be greatly facilitated by strong fiscal adjustment that leads to small or evennegative credit requirements by the public sector. Tight monetary policy is no substitute for fiscal prudence. Thecombination of loose fiscal but tight monetary policy could exacerbate the tendency for the RER to appreciate ifhigher domestic interest rate attract additional short-term capital inflows.

In general, it would be counterproductive to try to reimpose strict capital controls. A more open capitalaccount brings increased access to international resources and results in efficiency gains in domestic financialmarkets as a result of increased competition. In addition, effective capital controls would be difficult and distortingto implement, especially since they may entail reimposing controls on current account transactions which wouldseverely undermine private sector confidence and policy credibility.

Source: P. Alba, L.L. Gunaratne and A. Jamshidi (1995).

13 This report draws on the World Bank's most recent review of public expenditures: World Bank, Sri Lanka - PublicExpenditure Review (1993).

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Box 4:Building a Structure for Stability

Based on the experience of other countries, Sri Lanka should consider setting-up institutional mechanisms thatbind the Govemment to prudent fiscal policies. The point is that although the benefits of macroeconomic stability arewell known to Sri Lankan policy makers. large fiscal deficits and inflation are a chronic problem, especially in therun-up to an election. While institutions or legislation cannot prevent governments from adopting short-sightedpolicies, they can reduce their likelihood by changing the balance of authority between institutions.

One approach which has worked well in many countries is to increase the degree of independence of theCentral Bank (CB) from the other branches of government. While the authority of the CB depends in final analysis onthe Government, laws and tradition can give the CB the autonomy to pursue price stability, even when it conflicts withother objectives. There is substantial empirical cross-country evidence indicating that the higher the degree ofindependence of the CB, the lower inflation (and its variability). For example, Cukierman, Webb, and Neyapti (1992)found that legal independence of the CB is an important determinant of inflation in industrial countries. Theirassessment of legal independence was based on how CB charters dealt with, for example, the number and relativepriorities of the objectives of the CB, and the legal restrictions on CB lending to the public sector. In developingcountries, the authors found de-facto indicators of autonomy, such as tumover of CB govemors, to be more importantin explaining inflation.

Another approach adopted by some countries is the "balanced budget law" or similar legislation that restrictsthe capacity of the govemment to run fiscal deficits. In Indonesia, the hyper-inflation episodes of the 1960s led thelegislature to approve in 1987 a law limiting expenditures to domestic revenues plus foreign assistance, whileparliamentary rules restrict the legislature's ability to review budget details. These restrictions are believed to havehelped the Ministry of Finance to maintain macroeconomic stability. A similar approach has been recently adopted inNew Zealand with the Fiscal Responsibility Act which states that the budget must be in surplus until a prudent level ofpublic debt is achieved, and that budgetary policies must be based on predictable tax rates. The Act also includesclear standards for full and frequent disclosure and institutionalizes accountability, and has been complemented withlegislation enhancing Central Bank autonomy. The results have been very positive: chronic deficits have beentransformed into surpluses and inflation has declined sharply.

Source: Cukierman, Webb, and Neyapti (1992); and the World Bank (1993): The East Asia Miracle.

22. Increasing Revenues. On the revenue side, the Government should be able to raise some 1%-2% of GDP by implementing measures that are also structurally sound. Some of the most important arethe following:

* introduce the VAT in a revenue neutral manner by limiting exemptions and the number ofgoods under concessional rates;

* reduce possible revenue losses resulting from the trade reform program by eliminating tariffconcessions and exemptions (on-going);

* rationalize BOI tax and tariff concessions (on-going);* continue to implement the tax and customs administration improvement programs and

introduce preshipment inspection for imports; and* increase cost recovery in public services, with due regard for affordability by the poor,

including in the areas of irrigation, water, electricity, rail transport, education and health (asdescribed below). In addition to generating funds, raising tariffs towards their economiclevels will improve efficiency in use and is critical for attracting private investment. Raisingpower tariffs in particular would also have strong positive environmental effects by improvedenergy use efficiency.

23. Privatization proceeds. from the sale of capital assets, should be seen not as a substitute forthese revenue sources, but as an opportunity to reduce interest costs through debt reduction. thereby gainingmuch needed fiscal space.

24. Restructuring Expenditures. On the expenditure side, over the medium-term the Governmentneeds to reduce expenditures by some 4%-5% of GDP while changing their composition towards physicaland social infrastructure which cannot be left to the private sector. Care needs to be taken that expenditureadjustments do not compromise social and growth objectives by protecting capital and key recurrentspending in priority areas of infrastructure, agriculture and the social sectors, including more adequateprovisions for operations and maintenance. This suggests that much of the adjustment will need to comefrom restraining the civil service wage bill and cutting integrated subsidies and transfers, the source ofmuch of the slippage in 1994. There is scope for immediately reducing the fiscal burden of these transferswithout jeopardizing the government's poverty alleviation goals. Over the medium-term, as the policy ofno new net domestic borrowing reduces the domestic debt/GDP ratio, there would also be substantialsavings in interest payments. And, of course, achieving peace is critical since, among other reasons, itwould lead in the medium-tern to deep reductions in defence expenditures.

25. The Cost of the Civil Service. Because of over-staffing and an unfunded pension scheme.the fiscal cost of the civil service'4 is high (about 6%-7% of GDP in recent years). To reduce costs, akey short-term priority is to strictly limit new hiring into the civil service by canceling unfilled positions,reimposing appropriate central control over hiring, and refraining from hiring unemployed graduates intopositions for which they are unsuited, such as teachers. The public sector cannot be the employer of thelast resort. Over the medium-term, there are large potential savings by increasing the cost-efficiency of thecivil service through a reform of public administration. Reducing the wage bill would also entailmoderating the pace of salary increases, and linking wages and other benefits to productivity, especially forthose echelons of the public service who are paid in-line or more than their comparators in the privatesector. Over the medium-term, the establishment of a capitalized public pension scheme with benefitslinked to length of service and employee contributions would also reduce costs.

26. Reducinz Subsidies. The transfer and subsidy programs for the poor, which entail largeexpenditures,"5 face severe targeting and efficiency problems. For example, some 40% of all householdsreceived food stamps, including households with middle and upper-middle incomes, while the recentlyintroduced flour subsidy is not targeted at all. Ineffective targeting and administrative difficulties results ineither low support levels for the truly poor in order to meet fiscal targets, or in unsustainable spendinglevels. The transfer programs may also have disincentive effects in rural labor markets by raisingreservation wages. Untargeted production and consumption subsidies are costly and inefficient. They canalso be inconsistent, as seen, for example, in the case of the flour subsidy which negates the effect of thefertilizer subsidy on rice farmers. The later in turn has negative environmental effects and the bulk of itsbenefits accrue to richer, larger farmers. Consolidation and greatly improved targeting as discussed below(see Section IV) will result in critical savings while conserving generous safety-nets for the most needy.The Government's recent initiative to consolidate some of the transfer programs into a better-targeted newprogram is an excellent first step. However, the more costly, ineffective and distortionary programs, suchas the flour and fertilizer subsidies (between 1%-1.5% of GDP in 1995), should be eliminated as quickly aspossible. The Government has recently begun to reduce the flow subsidy but progress is slow.

27. Increasing the Efficiency of Public Investment. There are also potential savings in the publicinvestment area. First, low priority investments in the public investment program could be pruned, in

1 4 Including wages. salaries and pension benefits.

5~ Including food stamps, Janasaviya, the mid-day meal program, the flour subsidy, the fertilizer subsidy, free schooluniforms, and public assistance.

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particular projects regarding block transfers for projects to be chosen by parliament members, contemplatedexpansions of the irrigation system (such as the Moragahakanda system) and activities that can be handledmore efficiently by the private sector.6 In this context, the planning and programming part of the capitalbudget needs to be strengthened, in particular all projects should be vetted through the PIP process beforebeing included in the capital budget. In the past, investments by state owned enterprises financed outsidethe budget but with Government guarantee have been the largest and most doubtful public investments(including new planes for Air Lanka, the 4,000 bus scheme, and overly subsidized rural electrification).Recent Government actions to reduce the magnitude of these problem projects should be pursued further.Finally, and in the long-run most importantly, continued privatization and restructuring of state enterpriseswould reduce current and capital transfers. In addition, privatization in the sense of opening new areas ofinfrastructure for private investment will allow meeting needs without straining public resources.

28. The Implications of Peace for the Budget. While peace will strongly increase Sri Lanka'slong-run growth potential, it is also likely to exacerbate budgetary pressures in the short-term.Reconstruction needs, refugee resettlement and demobilization will require substantial resources, whilereductions in military expenditures will probably take time to effect. Indeed, international experienceindicates that the budgetary dividend of ending a civil war is small or even negative.'" While donorassistance will help fund these needs, the danger is that large scale donor financed reconstruction andresettlement expenditures will bid-up the prices of non-tradeable goods and services. In turn, this increasewould raise costs for export activities leading to a loss of external competitiveness of the economy as awhole.'8 To avoid this result, some hard choices will have to be made between reconstruction needs andother expenditure priorities. The redefined macroeconomic framework should maintain strong downwardpressures on other, especially current, expenditures and space reconstruction over several years. Of course,the further along is the process of fiscal consolidation, the easier it will be to manage the short-termbudgetary implications of peace, thus reducing the political dangers of peace being associated withincreased budgetary sacrifices.

C. Strengthening the Civil Service

29. A reform of the civil service will be at the heart of the Government's efforts to improve theefficiency of the public sector, and effect savings. It is also a key element of any effort to build aninstitutional framework supportive of well functioning markets and the private sector. The East Asianexperience (Box 5) demonstrates the vital role played in the transformation of that region by a reputableand efficient civil service insulated from narrow political pressures. The Government's Economic PolicyStatement clearly spells out what it sees as the essential role of the state: "to provide an institutionalframework that is wholly supportive of rapid private sector development", and to intervene "where marketsfail to function effectively." For the state to perform such a role efficiently, it must undergo a profoundchange. In the open Sri Lankan political context, the new Government's emphasis on accountability andtransparency is also clearly highly appropriate. The tendency to divert public resources for private gain orto indulge in rent-seeking undermines public confidence in government. This section, therefore, elaborateswhat is needed to restore Sri Lanka's civil service to its previous strengths, to improve accountability andincrease transparency.

30. Obiectives of the Reform. The first three decades of Independence saw a substantialexpansion in the role of the state. To the traditional functions of law and order, defence, revenuecollection and the delivery of essential services (such as education and health), were added new functions

16 Such as the four new agriculture marketing boards and marketing activities planned under the Govi Sevana program.

17 Azam et. al. (1994).

18 Both past experience and empirical evidence suggest that Sri Lanka is susceptible to this problem. See para. 18.

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Box 5:Building Institutions: The East Asian Experience

The East Asian Miracle study credits the following institutional factors for the remarkable perfonrnance ofthose economies:

Wealth sharing programs designed to enhance political legitimacy by including non-elites ineconomic growth. The approaches varied from country to country but included measures to ensureuniversal education, equitable land holding and land reform, emphasis on small and medium sizedenterprises, enterprise-based labor unions to work closely with management at the management level,and national wage councils to ensure harmonious relations at the national level;A cadre of economic technocrats insulated from narrow political pressures. The powerfuilEconomic Planning Board in Korea which enjoyed considerable freedom of action is a notableexample. This was particularly important in macro-economic policy and debt management.A reputable civil service. This was achieved through recruitment and promotion policies which werehighly competitive and based on merit, compensation packages that were broadly competitive with theprivate sector, and ample rewards for those who made it to the top. The most notable example wasKorea where the civil service in 1960 was widely viewed as corrupt and inept and within two decadesdramatically changed its image. Finn policies for dismissal in the event of corruption also helped,particularly in Singapore.

* Sound legal and regulatory environment. Date from the World Competitiveness report shows thatthese countries were regarded widely as having successfully created a legal and regulatoryenvironment conducive to private sector development.

* Formal institutions to share information and win support from the business community.Deliberations councils, as in Japan, consultative Committees as in Thailand, wages councils as inSingapore have all helped to facilitate infoniation transmission in both directions. with industry andtrade learning about government thinking about policy and with govemment learning about globalmarket trends, technology issues, and constraints to development.

emanating from the state's assumption of the role of initiating and promoting economic development.These new functions included development planning, public investment in and control over economic andsocial infrastructure, and state dominance over the economy. This expanding role was within the contextof the highly centralized government inherited from the colonial era. It was only in the 1 980s that thesetrends came to be checked and gradually reversed. The economic reforms launched in 1978 placed muchgreater stress on the role of the private sector. The 13th amendment to the 1978 Constitution passed inSeptember 1987, states that a "centralized policy is not only unworkable and counter developmental butalso a continuing threat to the unity character of the state". However, the process of redefining the role ofthe state and devolving power to lower levels of government has barely begun. Four areas deserve priority

attention:

shed activities that could be done better in the private sector or that have lost theirimportance. Despite recent privatization efforts, this process has not moved very rapidly.Candidates for consideration, including industrial activities, food marketing, banking, andinfrastructural services such as telecommunications. In addition, there are units ingovernment, for example, responsible for foreign exchange controls, whose functions havebecome obsolete. The ultimate goal must be a much more focussed role for government sothat it does fewer things and does them better.strengthen government's capacity to deliver essential services where markets cannot berelied on (e.g., an efficient and humane law and order machinery, primary education, basichealth and social safety nets). The objective here is to ensure that the day-to-day interfacebetween the providers of services (municipal services, water, electricity, etc.) and the generalpublic, and particularly the poor among them, is one that is free of harassment and corruptionand brings credibility to government rather than distrust.strengthen government's policy and regulatory roles so that it can better manage amarket economy. Improved macro-economic and sectoral policy making, including

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increasing availability of data and information on the economy, are essential. So arebalanced regulations that protect the public (e.g. safety standards, environmental regulation)without imposing unsustainable costs on businesses; that provide a hospitable but competitiveenvironment for foreign investment; and that ensure financial prudence among banks andother financial institutions as well as competitive and fair practices. These are relatively newfunctions which will require skills not easily available within government and a matchinglegal framework.develop and implement a comprehensive and coherent approach to devolution. Amongissues still to be resolved, some seven years after the passage of the 13th amendment to theConstitution, are a clear understanding of the relative powers of the Center, the ProvincialCouncils and local authorities. There is still confusion and overlap of functions and staffingat all levels of government. Developing a comprehensive approach to decentralization isintimately related to the peace process. However, the devolution process should notcompromise macroeconomic stability.

31. Past Attempts. Past efforts to restructure the civil service have proved singularlyunsuccessful, never enjoying strong political support. The Administrative Reforms Committee's (ARC) 10volume report issued in 1987-88, market the first comprehensive post-Independence look at the country'sadministrative system.'9 Box 6 provides extracts from the ARC's report that diagnoses the problems asthe Committee saw them. The ARC was deeply conscious of the interrelated nature of the reform processand pleaded strongly with the Government that "its recommendations be considered in totality andimplemented as a whole". The recommendations were comprehensive and far-reaching. They included theestablishment of a Minister of Public Service to manage the process of reforms in the human resourcesarea; the creation of a new Public Services Commission with enhanced authority to ensure an independentprocess of recruitment and civil service discipline; the constitution of a Senior Management Groupresponsible for policy, crisis anticipation and control and providing leadership to the public service;reduction in the size of the civil service by 20 percent together with improvement of the compensationpackage, and the institution of a strong organization and cadre management function. The committee alsorecommended reducing the numbers of ministries and departments and the restructuring of the systemconsequent on devolution and decentralization.

32. Ignoring the ARC report's injunction, the government accepted a few recommendationsrelating to salary restructuring and the creation of the permanent Cadre review commission.0 Thegovernment attempted in 1990-91 to reduce the size of the civil service. However, it chose an expensiveway of doing so by offering overly generous severance packages, which resulted in 68,000 staff retiring -many of whom were the civil service's most qualified and senior staff. Subsequently, many of the latterwere replaced or hired back as consultants. Efforts at freezing recruitment were not consistentlyimplemented, especially since mid-1993 when staff numbers started rising rapidly. All this negated theimpact of the whole exercise. Similarly, little was done to improve government salaries at senior levels.Real wages and staff of higher level officers has declined by 60 percent in real terms according to theSalary and Cadre Review Committee, resulting in a 4:1 differential in salaries between senior publicservants and their counterparts in the private sector; while salaries for lower level staff remain competitiveor higher than the private sector. There was also an effort to consolidate the number of cabinet ministriesand streamline the government, though here again its impact was diluted by subsequent decisions to addfresh management layers in the consolidated ministries. There were two subsequent but half-hearted effortsto launch systems-wide reforms based on the ARC recommendations which predictably met with failure.

19 See Government of Sri Lanka: Reports No. 1-10 of the Administrative Reforms Committee (1987-1988).

20 The former chairman of the Committee has set out his views on how to reactivate the reform process in a useful

analysis of the unfulfilled agenda. See S. W\anasinghe (1994).

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Box 6:Report of the Administrative Comnitlee

Extracts:

"The frequcnt change o0 nationial po!icies and strategies has a signiticant correlation to the poor state of healthin whichi one finids the administrative sxstem todav. From Limile to time, with changes in government, the system hashad to cope with several drastic chaniges in development policies. strategies and approaches. These changes. in turn,have demanded chaniges in attitudes, approaches and skills on the part oft civil servants. But at no time have there beencommensurate efforts at retraining and retooling of the administrative cadres to generate the desired changes. If ever aproblem was recognized, the remedy attempted has been to induct political cadres into the administrative system. withmarkedly mixed resulted. The attempts to introduce new political inductees without the ability to retrench the oldresulted in the continued burgeoning of the public service cadres".

The committee identified three sets of deficiencies:

Structural Deficiencies:* the absence of a pLiblic scrvice personniel functicni withi adequate authority and appropriately located;* the proliferation of departments, ministries. authorities and enterprises leading to serious problems of

coordination. planiing, programming and implementation;* the lack of eftective "decentralizationi, delegation and devolution ot authority and responsibility within

the administrative system": and* the failure to define the "policy and procedural framework within which the different forms of public

enterprises and authorities would function";Deficiencies in the Personnel System:

* weak cadre management: lack of discipline in creating new posts, and no process of eliminating costs,functions, institutions which are no longer relevant:

* inadequate salaries at the management and higher technical levels:* neglect ot training and management development functions;* lack of managerial leadership of the civil service;

Procedural Deficiencies:* weaknesses in public financial management;* lengthy. multi-step, multi-stop work processes: tedious and rigidly insisted upon input requirements

from the citizen:* lack of on the job. physical supervision in public sector offices;* mystification of work systems and procedures conferring powers of corruption on the bureaucracy;* failure to utilize computers for management information systems and communications.

33. And yet, most of the ARC recommendations remain valid today. That civil service reform isurgently needed can be seen from the increasing proportion of the national product that the Government isabsorbing, the fact that public spending appears out of control, that corruption in government is a majorissue, and that there is growing dissatisfaction with the quality of services delivered to the public and withthe corruption associated with such delivery.

34. Next Steps. However, if such reforms are not to meet the same fate as earlier efforts, thefollowing preconditions must be met:

there must be both a broad consensus on what kind of civil service is needed and a strongpolitical commitment to the reform process at the highest level; andplanning and implementation of the process must be well-organized and centrally located in aunit which enjoys a high profile and the full backing of the political leadership. Establishingclear lines of responsibility for implementing the reform is essential.

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35. The reform process will include a review of the size, composition and management of thecivil service, as well as a parallel review of the structure of government. The latter would entail a re-assessment of the size and functions of the public administration with the view of eliminating ordownsizing units with obsolete or less important function, and of simplifying administrative structires.The main staffing implications are an overall reduction in the number of staff, its redeployment fromfunctions that are less necessary to those that are more important. given the redefined role of the state, andfrom the center to lower levels of government, and the acquisition of new skills. Early attention to people-management is vital; it is important to alleviate the sense of insecurity that inevitably accompanies reform,to involve staff in the process of change, and to provide training in the new skills that staff will need. Akey measure here is to re-establish the independence and capacity of the Civil Service Commission toensure an independent process of recruitment, management and discipline.

36. Enhancing Accountability. Financial accounting, reporting and auditing systems are not thetools for inanagement and political accountability they once were. Although the system is generallyconsidered to be well-designed and, in the words of one recent authoritative reviewer, "operated bydedicated, skilled staff who perform an amazing array of diverse tasks," the system has "significantweaknesses which have led to a loss of financial control."2" These weaknesses include reduced legislativeoversight arising from the tendency of a powerful executive branch to crowd the Public AccountsComminttee of Parliament with members of the ruling party; the proliferation of government entitiescomplicating financial control; the lack of adequate capacity to cope with the volume of work; and the lackof accountability of the Chief Accounting Officers who see no penalties to delayed accounts or promptaction on audit objections. Thus, the system is subject to "significant delays in submitting, auditing andinvestigating accounts and in printing the relevant reports, which makes public accountability into ahistorical and largely irrelevant process". To remedy the situation, the immediate priority is to create astrong political momentum behind the restoration of financial controls through legislation that restores thepowers of the Ministry of Finance, through a code of conduct for accountants and auditors (as inIndonesia), and through revitalizing the role of parliament's Public Accounts committee. Also critical isinsisting on prompt financial reporting and auditing, holding the chief accounting officers personallyresponsible for such reporting and for follow-up action on audit recommendations. In the medium term,the needs are to strengthen the staffing and training of accountants and auditors throughout government,introduce modern automated systems of budgeting, accounting and auditing, and strengthen the workingand independence of the office of the Auditor General.

37. Micro-level Accountability - Accountability also needs to be strengthened at the micro-level,where government agencies are delivering essential services such as water and health care. Competitiveprovision of services by the private sector could enhance the public suppliers' accountability. Wherecompetition does not exist or is not possible to create due to the nature of the service, users' participationin improving coverage ur quality of services could make service providers more responsive to users' needs.Sri Lanka already has several of such 'voice' mechanisms. The Office of the Ombudsman is now directlyaccessible to the public without going through parliament. Some govemment offices have weekly so-called'open days' when all senior officials are made available to the public who bring in their problems. Civilservants are meant to be accessible for 24 hours a day, thus the residence phone numbers of key officialsare made public. More recently, several government programs have established interactive mechanismsbetween communities and urban local authorities. Non-governmental organizations and community-basedorganizations are quite active, providing choices of alternative services or self-help. Yet they are neithercoordinated enough to form strong pressure groups nor financially independent to be self-sufficient.Overall, in spite of the mechanisms for accountability in place, the system is highly politicized and themost effective approach to solve problems seems to be the use of political contacts and favors.International experience suggests that the most effective way to increase the 'voice of the voiceless' is to

21 The following discussion draws heavily on P.N. Dean (1994).

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strengthen monitoring mechanisms of service coverage and performance, especially to the poor, andcommunity participation.

38. Increasing Transparency. The Government has rightly stressed the importance ofenhancing transparency and reducing corruption. Corruption in Sri Lanka received a boost from theentrepreneurial spirits that were unleashed following the liberalization of the economy. But it could havebeen held in check but for the apparent emergence of corruption at high levels of government, mostlyrelated to large public procurement orders. With corruption prevailing at the top, it was difficult to controlcorruption elsewhere, and it is now believed to be fairly systemic at lower levels of service delivery.

39. The new Government is trying hard to crack down on corruption. It has established a three-member permanent semi-judicial independent commission to Investigate Allegations of Bribery orCorruption22 supported by the appointnent of a Director-General for the Prevention of Bribery andCorruption, and has strengthened the provisions of the Bribery Act.23 Experience elsewhere suggests,however, that efforts to arm the government with legal powers to deal with corruption when it occursworks best when matched with efforts to strengthen institutions and address some of the underlying causesof corruption. Some of the most important are:

(a) Reducing opportunities and incentives for rent-seeking activities:

* Trade and Tax Reform, based on lower uniform rates and simpler, clearer rules and thestrengthening and computerization of tax administration and record-keeping. The reformshould limit discretion of officials by replacing administrative controls with price mechanismsand by providing open access to good valuation data on imports.

* The removal of public sector monopolies through privatization or introduction ofcompetition wherever this is feasible, ensuring always that privatization itself is a highlytransparent process and not another opportunity for corruption. Where privatization is notfeasible, efforts are needed to increase accountability of public sector monopolies along thelines described above.

(b) Strengthening institutions to improve controls:

* Restore a professional, accountable, competitively-paid civil service. Only when aprofessional environment has been created is it possible to isolate and ruthlessly punish thosecivil servants who through their actions bring blame on the whole profession.

* Strengthen pubic procurement systems, through more transparent procedures, adoption ofimproved bidding documentation, competitive bidding, independent evaluation of bids, andstaff training. For IDA-funded projects, for instance, the use of IDA's Standard BiddingDocuments is mandated. It was recommended to establish standing tender boards within eachdepartment with regularly scheduled meetings and altemate members.

* Improve information systems so that all public actions are open to public scrutiny byproviding greater access to information, and publicizing all decisions and procurementawards. In this context, a responsible and vigilant media is an important safeguard againstcorruption. Local NGOs can also play a role as watch-guards against corruption.

22 Government of .iri Lanka, Commission to Investigate Allegations of Bribery or Corruption Act (1994).

23 Government of Sri Lanka, Bribery (Amendment) Act (1994).

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D. Promoting Private Activity and Employment

40. As noted above. Sri Lanka made major strides in the 1980's and 1 990's in creating anenabling environment to encourage the private sector, and the response of the economy has beenencouraginig. However, the outstandinig reform agenda is still large. This is particularly true in agriculture,where growth performance has been m1ixed. In addition, given the historical experiences outlined above,private confidence in the reform effort is not strong. In genieral. the private sector's views on thedesirability of investing in a country can shift quickly as demonstrated by the recent volatility in someemerging markets. Hence, the Governmenlt needs to pursue tlhe reform program steadfastly and in an openmaniner. Based on various sLirveys and studies, policy reforms in thiee areas are of highest priority.2 4

First, completing the ongoinig reform ot' trade and tax policies would enhance competition and eliminateprice distortions. Second. restrictions in the use of land are helieved to impair agricultural growth.Finally, improvements in the financial system, together with better macroeconomic polices, wouldencourage savings and allocate them more efficiently. In the medium-term, a thorough review of the legalframework would reduce transaction costs and encoulage investment. This section will now describe thesepolicy reforms in more detail. Labor market issues are reviewed in tile next Chapter.

41. Trade and Tax Policy. Sri Lanka has become an export oriented economy and trade policyhas gradually been liberalized since reducing protection is essential for export promotion and enhancingcompetition. In manufacturing, progress has been strong. Most recently, with the 1995 Budget, theGovernment has adopted a three band tariff structure for manufacturing with a maximum tariff of 35%.The Government has announced further tariff simplification and liberalization with the objective ofadopting a single band structure at 15% by the year 1998.25 A review of other forms of protection such assurcharges and discriminatory mark-ups on domestic indirect taxes applied to imports would complementthe tariff program. This is to be done with the introduction of the VAT later this year. In addition, theGovernment is reducing the number of waivers and exemptions and instituting transparent and non-discretionary procedures to cut down on administrative costs, enhance revenues, reduce incentives forcorruption and ensure a level playing field.26

42. In contrast, progress in trade policy reform in agriculture has been weaker. The sectorremains heavily protected, especially through a variety of quantitative restrictions. From time to time,however, all inport restrictions are lifted temporarily when the authorities are concerned with food priceinflation, causing wide fluctuations and uncertainty in the incentive regime. The immediate priority is toinstitute a tariff based, more stable protection system. Over the medium-term, reducing protection levelswould eliminate the current strong anti-export bias of the trade regime.

43. Another objective of tax policy reform is reducing the distortions resulting from the domestictax and investment incentive systems. Sri Lanka has in the past favored a complex incentive regimecomposed of high tariffs, high corporate taxes mitigated by extensive duty exemptions and tax holidays.Sri Lanka is now moving in the direction of an incentive regime closer to the East Asia model, based onsimple, easy to administer pro-investment and pro-export tax codes with neutral and low corporate taxes.This simplified system also has the advantage of reducing opportunities and incentives for corruption.Implementation of the new system concurrently with further gradual reductions in corporate tax rates arethe next steps in the reform of the incentive regime. In the area of indirect taxation, the authorities plan tointroduce the VAT in 1996. The VAT would eliminate many of the distortions of the current sales tax and

24 Overall, this section is based on World Bank, Sri Lanka - Private Sector Assessment (1994).

25 H. E. Kumaratunga. Economic Policy Statement of the Government of Sri Lanka (1995).

26 rariff reform may also have a positive environmental impact. In particular. high tariffs on cement may have

accelerated coastal erosion by encouraging increased mining of sand and coral.

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excise duties and should be introduced quickly. The Government is also considering pollution charges forfirms to internalize the cost to society of pollution.

44. The Land Market and Agriculture. The growth record of agriculture (19% of GDP)2" inSri Lanka is weak. The performance of plantation crops like tea, rubber and coconuts (4% of GDP), hasbeen very poor. Productivity growth in the non-plantation crop sector (15% of GDP), especially paddy,(4% of GDP) has also been weak. In both cases, inefficient use of land partly explains this weakperformance. However, in contrast to the plantations sector where solid analytical work is available, non-plantation agriculture has been less studied. The relative importance of land issues and other policy factorsis not well understood. For example, as noted above, trade and price policies for non-plantation crops aredistorted and fluctuate considerably from year to year and between seasons. In addition, there is substantialintervention by the state in food marketing. A joint Sri Lankan and World Bank team is analyzing non-plantation agriculture to identify policies to improve growth in this subsector and reduce rural poverty.The following reforms that reduce restrictions on land use and ownership are of special importance:

(a) State-Owned Plantations. Reviving the plantations sector may require a special private/publicpartnership. In 1992. the Government broke up the two larger state-owned plantationcompanies into some 25 companies and transferred their management of these companies tothe private sector under 5-year contracts. While financial performance improved in somecompanies, overall the sector runs at a loss and investment has been insufficient. Investorswere reluctant to increase their exposure in the plantations under these contracts given thelong lead times for replanting and other investments. To solve these issues, the Governmentis privatizing the plantations and is extending long-term leases on the land to the companies.For social reasons, the plantation workers will receive a share of the equity. Anotherimportant measure that would help re-assure private investors is allowing labor disputes to beresolved through collective bargaining without State intervention.28

(b) Land Market Reforms. Agricultural potential and farm incomes are being impaired byrestrictions on land use and ownership that favor paddy production. Diversification intohigher value-added crops, in particular fruits and vegetables, would require significant areasof land to provide the critical volume to assure buyers of continuity in supply. However,with much (62% of agricultural land) of the land publicly-owned, policy restrictions on landuse and ownership are of concern. Despite the 1991 amendment to the Agrarian Services Actenabling the reallocation of land from paddy to other crops, there still remain significantrestrictions on greater diversification of land use. Farmers in settlement schemes still do nothave full private ownership and procedures for transfers of public land are complicated.These restrictions are also reducing incentives to better conserve the value of land throughsoil conservation

45. The Financial Sector. According to a survey of private business,29 the high cost of financeis the dominant obstacle to expansion and diversification in manufacturing. The spread between the primeand the weighted average deposit rate has been larger than 6 points over the last few years. Factors whichlead to high interest rates are the large fiscal deficit (i.e., high domestic financing requirements), politicaluncertainties, a concentrated market structure in banking and low domestic financial savings. With regardto the latter factor, the financial sector in Sri Lanka is shallow as indicated by the low deposit to GDP ratio

27 Excluding forestry and fisheries.

28 World Bank: Sri Lanka - Tree Crops Strategy (1994).

29 World Bank: Sri Lanka - Private Sector Assessmnent(1995).

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and the narrow range of financial instruments available. Sri Lanka has been implementing, with somedegree of success, a program of measures to improve the depth and efficiency of financial markets and toincrease financial savings. In addition to macroeconomic stability, the main areas of reform are: (a)promoting efficiency in the banking system and capital markets; (b) promoting secure long-term savingsmechanisms; (c) maintaining saver confidence by coping quickly and effectively with distressed financialinstitutions and by appropriate regulations; and (d) gradually opening the capital account.

46. The Banking System. Probably the single most important medium-term measure to improveefficiency in financial markets is to privatize the two state-owned commercial banks (SCBs), especially thelarge Bank of Ceylon.30 Compared to banks of similar size throughout Asia, they are among the mostinefficient, largely as a result of government mandated policies on lending, as well as hiring, compensationand deployment of staff. Although the number of private banks is large, the SCBs control more than 60%of the market share. Hence, they are able to play the role of market makers in determining spreads, helpedby the weak competition in commercial banking. Private banks seemingly are taking advantage of theselarge spreads to increase profits. Hence, to increase competition, and reduce interest spreads and bad loans,an important step would be privatizing the SCBs. Of the two SCBs, Bank of Ceylon seems the best choiceto start the privatization program, as a single unit or, given its market power, in two or three parts. It has ahistory of private ownership, is mainly urban based, and because of less government interference and bettermanagement practices, it more closely resembles a commercial bank and is in a stronger financial position.Peoples Bank could then follow. While the privatization effort is being prepared, ongoing efforts toimprove the efficiency of the two SCBs and even the playing field for the private banks should bestrengthened.

47. Capital Markets. Treasury and private debt securities have a large potential for expansion.However, there are both regulatory and institutional deficiencies that constrain the development of thesemarkets. Among the most important is the lack of well functioning markets for government securities,especially those with maturities of 6 months or longer. Secondary markets are practically non-existent,especially at long end of the market where even the primary market is not yet well established. Theresulting lack of liquidity increases the riskiness of longer-term treasury instruments, which is alreadysubject to risk from high and variable inflation. In addition, without a secondary market there is noreference price for medium- and long-term private debt. The regulations governing portfolio managementof the two important public pension plans (ETF and EPF), among the most important sources of long-termsavings, also constrain the development of the demand side of capital markets. These two plans mobilizelong-term funds but are forced to lend short, because regulatory restrictions oblige them to hold the greatmajority of their portfolio in short-term public securities. The lack of credit rating agencies is anotherinstitutional factor constraining the demand for private paper although in a small market like Sri Lanka itshould be less important. Finally, there is a relatively long list of less important legal and technical issues(e.g. scriptless securities are illegal, providing guidelines for issuing Banker's Acceptances, etc.) that alsoneed to be resolved.3'

48. The Government has already undertaken reforms to encourage the development of capitalmarkets, including establishing a relatively well functioning primary auction market for 3 month T-bills.There are various options available to the authorities to accelerate the development of a secondary marketfor these instruments. First, changing regulations for primary dealers to allow them to hold T-bills on theirown account would help establish a more active secondary market. Second, the Government shouldencourage the establishment of credible rating agencies. However, direct Government involvement couldbe counterproductive. Finally, the EPF and ETF could review their investment strategies and take a more

30 W. HeUeriachchi (1995).

31 W. fletteriachchi (1995).

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active role in capital markets, although ensuring the appropriate risk return profile for pension funds. Theportfolio management skills of these agencies would need to be urgently upgraded, and the use of privateportfolio managers could also be considered.

49. Access to Foreign Capital Markets. Until very recently, strict capital account restrictionslargely cut off the private sector from benefiting from foreign investment. However, the elimination ofmost restrictions on FDI and portfolio investment has considerably eased this constraint. The next stepwould be to allow firms and banks to borrow on international debt markets. Some of the macroeconomicimplications of such a step have already been discussed above (Box 3). In addition, further liberalizationwould have both prudential and regulatory implications for the banking system as well as capital markets.On the prudential side, most importantly, the Central Bank would need to review the appropriateness ofcurrent prudential ratios, and reinforce their supervision of the financial system. in particular of the foreigncurrency banking units and the development banks.3 2

50. Strengthening the Legal Framework. A market based economy flourishes when theinstitutional framework provided by the state. i.e.. the rules of the game, minimize the transaction costsassociated with holding property and enforcing contracts. In the absence of the rule of law and a soundand efficient legal system, transaction costs can reach levels that greatly reduce economic activity.Moreover, foreign investment is much more likely to flow to countries where it is protected by a soundlegal framework. While Sri Lanka's legal system provides a basic protection against the excesses ofgovernment and infringements of property rights defined in the broadest term of the word, it hasdeteriorated over time. and several weaknesses have emerged. The key problems are the following.3 3

51. With respect to the framing of laws and their communication to the public, laws are notalways easily understandable and accessible. Public hearings and public representations in the drafting oflaws, are inadequate (with the exception of environmental legislation where the views of NGOs and otherswere sought). In addition, legal draftsmen lack a basic knowledge of commercial law and the need to draftin three languages (Sinhala, Tamil and English) imposes a significant strain on them.

52. With respect to the enforcement of law, in framing legislation which envisages significantexpansion of the regulatory and interventionist power of the state, little thought is given to the capacity ofthe state to enforce such legislation (e.g. the new Companies Law calls for detailed filing and reportingrequirements of companies, but the Registrar of Companies has no capacity to ensure compliance; similarlypiracy of music and video cassettes is widespread despite a sound Intellectual Property Law). Indeed, thequality of the iudiciarv and the efficiency of the court needs to be improved. The main areas of concernare the following:

* it is extremely difficult to recruit competent. imaginative and ambitious lawyers into thejudiciary because of the huge gap in incomes between judges and lawyers;

* civil litigation can take up to ten years, with disputes over land taking even longer;* the administration of court records is poor making the retrieval of information with regard to

pending litigation extremely difficult, resulting in abuse, corruption and inconvenience tolitigants;

* there is an urgent need to address the problem of corruption in the administration of justice,particularly in the services of summons, the release of money furnished as bail, the recoveryof compensation paid into the court, the forwarding of appeal briefs to the appellate court andthe access to court records.

32 W. Hetteriachchi (1995).

33 This section is based on the paper by Thiruchelvam Associates (1994).

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53. With respect to alternative dispute settlement inechanisnms. there are a large number ofcommercial and civil disputes in Sri Lanka which are subject to arbitration. However, these proceedingsare as protracted and costly as litigation since arbitration is typically conducted bv retired judges atweekends or late evenings and counsel are to busy to devote sufFicient time for these. The legalframework for arbitration is currenitly being reviewed with a view to drafting a new arbitration law ainedat making arbitration more effective.

54. With respect to the capacity for law reform, the Law Commission was established in 1969 to"keep under review substantive and procedural laws and to address the elinination of anomalies, the repealof obsolete and unnecessary laws and to facilitate the simplification of modernization of the law". TheCommission never fulfilled its proinise, and had becoime deftinct. Thle new government is taking steps torevitalize the Commission.

55. There is widespread agreement on the need for a comprehensive review of the legal system toensure the development of a healthy private sector. This would include a review of the Fair TradingCommission Act, acceleration of the ongoing reform of the Companies Act, a review of the laws relating tobankruptcy to ensure orderly exit, a review of about 46 labor laws, a review of public procurement laws toensure transparency and fair competition, a new legal framework for commercial arbitration and finally, acomprehensive review of all aspects of commercial and civil law which "have a negative impact on privateand sector development." This is a tall agenda. But it is also critical to the effective functioning ofinstitutions in Sri Lanka. Recognizing this, the Ministry of Justice is taking the lead in developing amedium-term program for a legal reform, and ensuring the availability of resources for its implementation.

E. Improving Energy and Infrastructure

56. Infrastructure services make a vital contribution to expanding and diversifying trade andproduction, coping with population growth and urbanization, and protecting the environment. However,during much of the eighties, Sri Lanka's investments in core infrastructure (transport, communications,water and power) fell below the typical range for low income economies of 3.5% to 4.0% of GDP.Investment in core infrastructure has increased marginally since 1990, to about 4.5% of GDP, it is still wellbelow the levels in lower and lower-middle income Asian countries such as Indonesia (5.5-6%), Thailand(6-6.5%) and the Philippines (7%). In contrast, the demand for infrastructure services has ballooneddramatically in the post-1989 period, and is placing a severe strain on the already overburdened and poorlymaintained infrastructure stock. For instance, power demand grew by more than 10% in 1993 in contrastto its annual average growth rate of 7% to 8% since 1970. In both quality and quantity of infrastructure,Sri Lanka is behind its South-East Asian neighbors.

57. The public sector's ability to increase infrastructure investment is severely limited because oflow levels of cost recovery and retained earnings in infrastructure corporations and the persistence of a highbudget deficit. The Government's strategy to redress infrastructural deficiencies has two components.First, it is creating the appropriate regulatory and policy environment to encourage supplementing publicinvestment with private resources. Second, the Government is improving efficiency in the infrastructuresector, including continuing the privatization/divestiture program and strengthening the remaining state-owned utilities. This section will try to describe more the main policies and mechanisms to implement thisstrategy.

58. Private Sector Participation. Sri Lanka has good potential to attract private financing ofinfrastructure projects through BOO/BOT schemes, in power as well as other sectors. There appear to besome common lessons across countries to bring about meaningful private sector participation ininfrastructure. In brief:

(i) Resolve framework issues - Complete sector specific legal and regulatory diagnostics todetermine the best avenues for private sector participation and establishing favorable

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regulation and policies. In the Sri Lankan case, this implies regulatory reform to open thesector to private investment and competition, to manage private providers, and to set-uptransparent decision-making and dispute resolution mechanisms. The telecom sector offers agood example of regulatory restructuring to orchestrate effective private sector competition,such as in cellular phone services. This leads to all-round benefits, especially for consumerswho receive better services at lower costs.3 4

(ii) Make the interface of private sector with Government efficient - To some degree. SIDIhas improved the line agency response to private sector overtures. However, its inability toclose deals quickly and continued line agency resistance suggest that additional actions arerequired. One option would be to clarify SIDI's role by legally entitling it with widerpowers to deal with the private sector on behalf of the Government. However, the short-termpriority is to deal with the lack of commitment of utilities and line agencies to BOO/BOT.Furthermore, the poor financial health of public utilities does not inspire confidence inwould-be investors. Hence, determined action to improve parastatal organizations that dealwith infrastructure would likely result in favorable investor responses; this action could itselfinvolve privatization in whole or part and in some sectors will likely need tariff increases(para. 59).

(iii) Channel official financial assistance to catalyze private sector interest and investment -rather than only promote public sector projects. This requires a tighter linkage between aidand policy interventions, as well as a clear message to public enterprises that the Governmentwould not favor "pure" public sector investments unless justified by the nature of theinvestment.

(iv) Address financing problems - Access to capital and debt markets for private sector sponsorsis likely to remain a significant constraint for some time. However, favorable action on theearlier issues would significantly facilitate sponsors access to international finance; bothequity and debt. In the near term, mechanisms such as the proposed Private SectorInfrastructure Development Fund can help to overcome financial market weakness and ensurethe availability of adequate debt financing.

59. Privatization. The continued operational weakness of Sri Lanka's publiccorporations/agencies in the infrastructure sector has led to serious implementation delays, inefficientservices, and large transfers from the Government's budget. The new Government is committed tocontinue the privatization program with the objectives to improve management; induce technology transferand modernization, in particular by encouraging foreign direct investment; and to spread the ownership tothe broad population. The areas in which the Government has decided to move forward with particularurgency in the economic infrastructure sectors are aviation (Air Lanka) and telecom at a second stage.

(i) Air Lanka. Traditionally, Air Lanka's operating margins have been poor and cash flow hasto service debt and meet lease payments. The financial situation is expected to deterioratesignificantly with the purchase of three A340 aircraft. Given Air Lanka's operatingcharacteristics as largely a niche operator with long-haul routes which face uncertainprofitability prospects, every effort should be made to appropriately dispose of the third A340recently delivered. In addition, the Government needs to urgently examine options fordivestiture. including foreign equity participation.

34 Start-up costs for cellular phone services have dropped ten-fold over two years; from $2,500 in 1992 when themarket had one provider, to $250 today. with four companies offering cellular services.

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(ii) Telecom. Basic local and long-distance telephone services are provided by the statecorporation Sri Lanka Telecoms (SLT). In order to improve its efficiency, one option wouldbe to divest a major part of the company's equity to a strategic investor and/or operator. Inline with experience of such divesture in other countries, the Government can expect toderive substantial fiscal benefits from SLT's equity divesture and resultant performanceimprovement.

60. Strengthening the Remaining State-Owned Utilities. Basically, two types of reformsshould take place in tandem to improve efficiency in the utilities that remain in the public domain:

(i) Government-led reforms - these refer to a broad set of issues on which Government has toact, in contrast to reforms that need action by the utility itself. These include; granting moreautonomy to public enterprises to set tariffs, moving from a "provider" to a "regulator"function, with lesser interference in their management and relinquishing subsidies and off-budgetary transfers in favor of more transparent fiscal mechanisms, such as public serviceobligation agreements with parastatals.

(ii) Institutional reforms - short of full blown privatization, public enterprises can undertake anumber of measures to improve their management capabilities. Corporatization, accompaniedby limited equity divestiture, private sector representation on the Board of Directors,commercial orientation and "unbundling" of services to encourage increased private sectormanagement of selected operations would bring about better performance and create a moreaccountable and efficient management culture.

III. Labor Markets and Employment

61. Operating in a relatively strong economy, the overall performance of the labor market in SriLanka has been good. It has been flexible enough to absorb many new entrants into the labor force, andhas been helped by continuing job opportunities in the Middle East. Nonetheless, open unemploymentremains well over 10% of the labor force and creating more and better jobs is high on the Government'ssocial and economic agenda for a number of reasons. First, unemployment is a significant source of socialtension. Historically, youth violence and discontent has been a serious recurring political and socialproblem in Sri Lanka, as evidenced by the JVP uprisings. In addition, a well functioning labor market iscritical for poverty alleviation, since labor is the poor's most abundant endowment, and for growth byhelping maintain external competitiveness and promote investment.

62. Increasing job opportunities, especially for youth, is one the Government's key objectives.Simple calculations suggest that, during the period 1994-2000, some 1.3 million jobs (about 190 thousandjobs p.a.) need to be created to provide employment for new entrants into the labor force and at the sametime reduce unemployment.5 This compares to about 120 thousand jobs p.a. during 1981-92.International experience suggest that both rapid economic growth and a high degree of flexibility in labormarkets would be required to achieve such an outcome. One important characteristic of many of thedynamic East Asian economies is flexible labor markets, where employment and renumeration are largelydemand driven, and the rapid pace of economic growth supported employment and incomes. In contrast,as discussed below, labor markets are more regulated in Sri Lanka. This section reviews the performance

35 The calculations assume that: (i) the labor tbrce continues to expand on average at 1.9% p.a. as during 1981-93; and(ii) the unemployment rate declines to 5%, a guess of the frictional/structural unemployment rate.

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of the labor market, and, in particular, the extent and composition of unemployment. It then outlines themost probable causes of unemployment and concludes by proposing policy measures to reduce it.36

63. Overview of the labor market. The labor force grew faster than population, partly becauseof higher population growth in the past and partly because of a 30% increase in female participation (Table2). The labor market has successfully provided large numbers of jobs in the context of relatively stronggrowth. It appears that growth, structural change, and a fLinctioning labor market contributed to jobcreation. Job creation was also associated with a relatively rapid expansion of exports, industry. and theprivate sector. Nearly all of the net increase of employment was in the private sector; employment in thebroadly defined public sector was stable because the privatization of many state enterprises since 1989compensated for the increase in employment in the Central Government. Over 1981-94, employment roseby 1.5 million or by 3% per annum, slightly faster than the labor force but not fast enough to reduceunemployment significantly. About 750 thousand people, or 12% of the labor force, remained unemployedin 1995.

Table 2: Overview of the Labor Market

Levels: 1994 Annual Growth: 1981-94 Rates: 1994(thousands) (in percentage points) (in percentage points)

Population b' 17,899 1.4Labor force' 6,117 2.5 labor force/active population 49.8Employmenta' 5,323 3.0 employment/labor force 87.0Unemployeda' 792 -0.3 unemployment/labor force 13.0

a/ Excludes the North and East provinces.b/ Estimates for all nine provinces.

Source: Labor Force Survey, Department of Census & Statistics & World Bank

64. Unemployment is concentrated among the young and is typically long-lasting: over three-quarters of the unemployed have been without a job for over a year. Rates of unemployment are especiallyhigh for new entrants into the labor force aged 15 to 19, and for youth aged 20-24, especially women inthose age groups: the female unemployment rate is about twice the male rate (Table 3). Women formabout a third of the labor force but half of the unemployed. However, most are not from poor families.The last household survey suggested that about two-thirds of the unemployed belong to households abovethe poverty line. Moreover, unemployment rates are still high for those who have a secondary schoolgeneral education "O" level or "A" level certificate. Combined with the fact that the vast majority ofunemployed are being supported by their families, rather than by government programs; this pattern ofunemployment suggests that some of the unemployed are waiting for the "right" job.

65. The Divided Labor Market. The labor market in Sri Lanka is characterized by its divisioninto segments. There are at least three distinct sectors: a protected and thus privileged segment, a lessregulated segment and the state plantations. The protected segment (about 25% of the workforce) consistsof the civil services, the state-owned enterprises, and some medium and large private enterprises. Theunprotected segment (68%) includes agriculture (except the plantations), small-scale manufacturing, somelarge manufacturers operating under the BOI, the service sector and the informal sector. The plantations(8%) are in a category of their own because of the limited mobility of their labor force.

36 This section is largely based on M. Prywes (1995).

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Table 3: Unemployment Rates by Group: Q4 1994(in percentage points)

Gender Male FemaleAged 15 to 19 35 48Aged 20 to 24 26 43Aged 25 to 29 10 24"O" Level education 10 22"A" level education & above 10 26

Urban RuralRegion 14.8 12.8

Note: Excluding Northern & Eastern Provinces.Source: Labor Force Suivey. Department of Census

66. In the protected segment employees receive numerous wage and non-wage benefits that areset, or at least regulated, by the government. Wages in the government administration and in most state-owned enterprises are determined by administrative order. Indeed, in 1990, government wages were morethan double non-government wages.3" The most important non-wage benefits are the retirement funds.Civil Servants benefit from a Pension Fund, which is fully funded by the Government, that pays a pension(or a lump sum settlement) on retirement. An Employee Provident Fund (EPF) and Employee Trust Fund(ETF) benefit employees of state-owned enterprises and private companies, except for family-ownedenterprises and the self-employed. The EPF is financed by employer contributions of 12% of the wage billand employee contributions of 8%; employers also contribute 3% to the ETF. Combining the threepayments brings the total social security tax rate to 23%. These payments offer impressive benefits toemployees but at a high cost. In addition, employees in the protected sector benefit from 26 publicholidays per year, and often from the two day weekend common in wealthy industrial countries. Anotheradvantage is that overtime and work on public holidays is remunerated at I and 1/2 times the standard rate.

67. Job security in the protected segment is another important benefit. Most significantly, theTermination of Employment of Workmen Act (TEWA) of 1971 prevents employers from laying-offworkers for non-disciplinary reasons without their agreement or the prior written approval of theCommissioner of Labor. The TEWA covers lay-offs motivated by the down-sizing or closing of a businessand even termination on the grounds of incompetence and prolonged illness. It is usually not possible toobtain permission for redundancies from the Commissioner of Labor and down-sizing obliges employers tooffer large settlements for voluntary retirement. The Labor Tribunals and the TEWA are applicable to boththe state enterprises and the private sector -- in principal. There are many reports that the TEWA is notalways enforced in parts of the private sector, or can sometimes be avoided by keeping employees onshort-term contracts or by encouraging high turnover.

68. Policy Options to Reduce Unemployment. The most significant source of inflexibility andof unemployment is the segmentation of the labor market. The high value of government-mandated wagesand benefits and of job security in the protected sector appears to motivate long-lasting search for a job byyoung and relatively well educated people. Thus there is a voluntary aspect to unemployment which could

37 A. Bowen (1990).

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be alleviated by changes in policies that unify conditions in the labor market and discourage lengthy searchfor jobs.

69. The most important recommendation is to end the practice of hiring massive numbers of theunemployed into the public sector. This practice backfires by encouraging young school-leavers to searchfor government employment rather than adapt themselves to the needs of private employers and then searchfor and accept private employment. The occasional and seemingly random nature of massive governmenthiring encourages unemployment by nurturing the expectation that employment in the Government could beachieved at any time. Extended efforts to find work in the Government also feed the frustration of youthand can be potentially destabilizing. The Government could also discourage extended search by eliminatingany government preference for hiring from the ranks of the unemployed and by linking public sector wagesto private comparators.

70. Massive hiring in the public sector of the unemployed has two additional negativeconsequences. First, the practice squanders the productive potential of human capital. In the worst case,workers in whom a substantial educational investment has been made are paid the relatively high publicsector wage to do jobs for which their marginal productivity is low or even negative--such as the case ofhiring secondary school graduates that are not qualified as teachers. Second, as already discussed, itcomplicates the control of government expenditure and is fiscally unsustainable.

71. However, the segmentation of the labor market is unlikely to explain unemployment amongpoor and relatively uneducated people who do not qualify for employment in the protected sector. Themain explanation of this kind of unemployment is probably the web of constraints faced by the poor interms of education, health, lack of assets, physical isolation and isolation from information. The difficultyexperienced by plantation workers in finding employment in non-plantation areas is also a contributingfactor, as is the limited mobility of women between occupations and industries. More research is needed tounderstand their relative importance for cost-effective remedial action.

72. Ultimately, a sustainable reduction of unemployment requires the creation of productive jobsin rapidly expanding labor intensive industries and services. Rising productivity in these activities willprovide the basis for increases in real wages and living standards. Dynamic enterprises, by necessity,operate today in a competitive, uncertain, even volatile, global environment. They require the flexibility tochange the level and composition of their labor force from time to time. Under these conditions, high costsassociated with labor turnover discourage labor hiring by existing enterprises as well as employment-creating investment. Such costs oblige businesses to bear the risk of paying large settlements. Existinglabor legislation (in particular, the TEWA) should be reviewed and modified where appropriate to balancethe legitimate concerns of both firms and employees. For example, there could be an upper bound toseverance pay while providing for a reasonable minimum period of advance notification of severance to theemployee. Such changes may increase turnover, but would reduce youth frustration by both limiting theduration of unemployment and giving youth an entry point into the job market.

73. Entrenched attitudes of hostility and mistrust between employers and employees make itdifficult to develop urgently needed changes in labor markets. In Sri Lanka, it is essential to strengthen thesystem of industrial relations. The system should encourage flexibility and productivity improvements inthe work place, and reduce disincentives to hiring by employers. It should also protect the basic rights ofworkers to organize themselves as they wish and to negotiate terms and conditions of work. Theseobjectives need to be achieved while reducing the number of strikes and labor conflicts. The Governmenthas strengthened its credentials with workers by accepting the Workers' Charter. It is essential to follow-up and bring all the parties together to discuss how to improve industrial relations.

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74. A final recommendation is to expand public expenditures in high-return and labor intensiveareas such as the maintenance and rehabilitation of roads. To avoid increasing the deficit, these activitiesshould be financed by cuts in current expenditures or increased revenues. A sustainable increase in suchlow-wage employment would support those in low and middle income levels while contributing importantlyto long-term development.

IV. The Agenda in Human Resources

75. Sri Lanka's achievements in developing human capital and completing the demographictransition are impressive. For example, Sri Lanka's social indicators in six critical areas38 remain abovemost of the East Asia Miracle countries, though they fall short of the level of the best performers such asKorea and Singapore. On the other hand, recent studies and analysis suggest that about 10% of primaryschool age children are not in school, the quality of primary and secondary education has declined, and thegaps among schools and regions need to be corrected. Malaria cases are high and undernutrition amongyoung children, while declining, is still substantial. As demonstrated in the East-Asian economies,investments in human resource deve'opment have a high social and economic rate of return, and are notmere "welfare expenditures".

76. The challenge Sri Lanka faces is to maintain and further advance the high level of humanresource development, and complementing the quantitative successes by emphasizing quality improvement.In particular, actions are required to improve the nutritional status of children, preventive health care, andthe quality of primary and secondary education. Assuring more equity of access and communityparticipation in decisions that affect them will help. In addition, Sri Lanka has to begin to deal with new"second generation" issues more typical of middle-income countries. For example, growing demand forhigher education has become an increasing burden on the already overstretched public resource base. Theaging population and associated changes in disease patterns is creating pressures for epidemiologicaltransition, more tertiary care with high treatment costs. Cost recovery measures and greater reliance on theprivate sector need to be explored, especially in the areas of higher education and tertiary health care.Hlowever, the Government should also explore whether the level of resources channelled into these areasneeds to be increased (as a ratio to GDP) over the medium-term, and whether the resource allocations tothe provinces are commensurate with their responsibilities for providing quality health and educationservices.

A. Education

77. There are several indicators that suggest that the key priority in the education sector is toimprove quality. For example, as noted above, unemployment among the educated is quite prevalent, whileemployers express difficulties in recruiting people with appropriate skills and training. In addition,examination results are disappointing which leads to high repetition rates. In view of the critical role ofwell educated and trained human capital in meeting the changing needs and technology in a moderneconomy, immediate actions are called for to improve the quality of education".

These are population growth rate, life expectancy. infant mortality, adult illiteracy rate, and total and femalesecondary enrollment.

This section draws heavily fiom: World Bank, Sri Lanka - Education and Training Sector Strategy Review (1994)

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78. These quality problems do not seem to be caused by an overall lack of resources ineducation. Public expenditures on education have not been low, averaging 2.7% of GDP and 9.6% of totalgovernment expenditure during 1991-93. The internal allocation by level seems reasonable with strongeremphasis on general education. However, the fiscal constraints over the next several years and the growingdemand for higher education call for more efficient use of resources. Two actions are particularlyimportant. First, teacher recruitment needs to be sharply curtailed. Second, an appropriate reportingsystem between the Provincial Councils and the central government needs to be established to strengthenthe monitoring capacity of the Government on the activities at the provincial level.

Primary and Secondary Education

79. The high coverage of general education as well as the declining fertility rate present a rareopportunity to improve the quality of general education even within the existing resources. Efforts shouldconcentrate on quality improvement by training teachers and providing more resources for items such asinstruction materials and operation and maintenance. A reduction in the repetition rates as well asredesigning welfare schemes (e.g., free uniforms) by enhancing targeting mechanisms could also generatesavings for quality improvements.

80. Curriculum and teaching methods. In view of the needs of the majority who leave school byyear Xl as well as the widespread unemployment among the graduates, the curriculum of general educationshould be reviewed to increase its relevance. A stronger emphasis on science, mathematics, and Englishwould help create much needed skills and knowledge in a society with a high international andtechnological orientation. Contents and teaching methods can be modified in such a way to fostercreativity and adaptability of students which enable them to respond quickly to the changing environment.This may imply increased teacher-student interaction and less rote learning. In this regard, the number ofschool days per year is relatively low and may need to be increased.

81. Equity. At present, quality varies greatly by school and by region. There also exist widediscrepancies in resource allocation per student between large and small schools as well as provinces.Particular attention should be paid to the rural areas where some schools lack basic facilities and sufficientnumber of trained teachers. Ensuring wider and more equitable access to quality education across thecountry is among the best poverty alleviation policies in the medium-to-long run.

82. Qualifications, training and incentives of teachers. The sharp decline in the training andexperience level of teachers is alarming. A large number of experienced teachers left through the earlyretirement scheme of the early l 990s and untrained young graduates were massively recruited asreplacements. Increased efforts for teacher training to upgrade their skills are necessary. New recruitmentof untrained teachers should be stopped, in particular because the pupil/teacher ratio is relatively low byinternational standards (22 in 1992). In addition, wages and salaries claimed over 70% of the governmenteducation expenditure in 1991 (97% of provincial expenditure). If the teacher recruitment policy of thepast few years continues, the 1992 salary bill will double by the year 2000. Low teachers' morale andhigh absenteeism are of serious concern. The Government has recently increased teachers' salaries toprovide incentives. Another option is that the newly established Teachers' Service review the current statusof teaching quality as well as teacher's working conditions, and formulate a medium-term strategy onteacher recruitment, training, and deployment, basing rewards and promotion more clearly on performance.

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Higher Education

83. Higher education has been supply-driven rather than directed at meeting demand. The sub-sector has not been expanded for many years, absorbing 2.5% of the age group. Close to three quarters ofemployed graduates work in the public sector partly because they lack the practical orientation andcommand of English sought after by private employers. An appropriate review of the role of universityeducation and the subject areas to be emphasized would increase its relevance to the private sector,including strengthening subject areas such as science and technology, and English training. A feasibletarget for growth in university enrollment needs to be set, while taking into consideration the qualityimprovement and the content review discussed above.

84. Increasing the enrollment and quality of higher education will require additional funding.The resource constraint requires the Government to find alternative sources to finance higher education,although the feeling against charging for higher education is strong. International experience shows that ifuniversities are to achieve higher quality and efficiency, alternative means for financing higher educationwill probably be required (Box 7). For instance, cost sharing with students can be introduced in a gradualand selective manner (e.g. non-tuition fees). The Government could encourage universities to pursueincome generating activities such as fee-charging short-term courses, contract research for the privatesector, and consultancy services. More autonomy could also help universities better manage their financialplanning.

B. Health and Nutrition

85. Overall, Sri Lanka has relatively good and well-functioning public health services with widecoverage. However, the service quality seems to vary among institutions, in particular, in overcrowdedtertiary facilities. Two other health issues are child malnutrition and the resurgence of malaria. As ineducation, the overall resource envelop seems adequate and the emphasis should be on more efficient andeffective use of resources. Relatively good health services and facilities already in place as well as lowfertility and mortality should make addressing these issues feasible within the current resources envelope.The private sector could also play an increasingly important role as an alternative or complementary sourceof health services.

Public Health Services

86. There is apparent overcrowding at public tertiary care institutions while in-patient facilities atthe primary and secondary levels are underutilized. Inadequate facilities and shortage of drugs at the lowerlevels are often cited as a contributing factor to this 'bypassing' problem. Improved services at theperipheral level as well as the establishment of an appropriate referral system should help reduce the'bypassing'. Private practice of public medical personnel is permitted and increasing. Steps should betaken that the system is not abused at the expense of quality of public health services.

87. The government expenditure on health averaged about 1.5% of GDP for 1980-93 close to theaverage of other countries in the region. While the Govemment may wish to consider increasedexpenditure on health in the medium term, the short-term goals should focus on a targeted approach withinthe existing resource level. The following are some of the priorities.

(a) Increased Attention to Preventive Disease Control. After a marked improvement in the1960s, the incidence of malaria is again on the rise and the morbidity caused by otherinfectious and parasitic diseases remains relatively high. A renewed effort to reducemorbidity, especially through anti-malaria programs, will be necessary, with an emphasis on

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Box 7:Financing Higher Education

Financing higher education is an ever greater challenge for both industrial and developing countries in the contextof recent fiscal crunch. The problems are more acute in developing countries due to the harsher fiscal retrenchment andfaster growth of demand for higher education. Many countries responded to the growing sub-sector by providing highlevels of subsidies in the past. The results are unsustainable fiscal burdens and deterioration of quality as resources forrecurrent and capital expenditures became scarce.

Diversification of financing sources as well as differentiation in types of institutions could help meet theincreasing demand for higher education at a lower fiscal cost while at the same time making higher education moreresponsive to market needs. East Asia is a front-runner in this approach, achieving higher coverage with lower publiccosts per student as compared to other regions. The specific measures vary by country. Thailand, for example,established two open universities and several regional universities to augment four national universities in Bangkok, whileIndonesia, Korea, and Philippines relied heavily on self-financed private institutions.

There is a strong case on equity grounds that some students bear at least part of the costs of higher education.This is because, first, a significant proportion of university students continue to come from relatively well-off families.Second, most of the benefits of higher education are captured privately as future incomes to individuals. In this way,tertiary facilities can be expanded in the near future without imposing unsustainable tax burdens.

Private financing of higher education usually consists of cost recovery in public education or the establishment ofprivate schools. However, the expansion of private financing has to be managed with caution in order to avoid adverseeffects. First, equity needs to be carefully taken into account so that lower-income students are not unproportionatelypenalized. For instance, direct subsidies to institutions can be transforned to subsidized student loans and/or scholarshipson merit. On the other hand, unless some cost recovery mechanism is introduced in public schools, increased highereducation could lead to higher regressivity. The most privileged, who have access to more resources, often have betterchances to enjoy free public education. In Thailand, almost three quarters of the students in the best public universitiescome from middle- to upper-class families. Finally, it should be noted that, given rapidly changing societies, predictingfuture needs in labor markets is not an easy task. The Chilean Government provided preferential financing to sciencecourses in the early 1980s, while there was no clear demand for such skills in the economy. Not only should suchpolicies be based on solid data and analysis, but they should remain flexible and allow students to respond freely toemerging labor market needs. Proponents of private education argue that private institutions can respond more quicklyand flexibly to the needs of students and labor markets, and provide services in an efficient manner.

Distribution of Higher Education Enrollments by Type of Institution, Mid-1980sGross Enrollment by type of institution Index of

Enrollment (% of total enrollment) OverallPrivate

Ratio (%) Public Distance Private Overseas FinancingaSri Lanka 5.1 62.0 28.5 0.0 9.5 20.5

Indonesia 6.5 32.5 8.8 57.7 1.0 48.7Korea 31.6 21.4 12.0 65.1 1.5 76.6Malaysia 8.6 60.5 1.0 7.6 30.9 35.1Philippines 38.0 16.7 0.0 83.0 0.3 85.8Thailand 19.6 14.5 77.9 6.3 1.3 26.9

at Reflects the rate of cost recovery across the institution types, weighted by their share of total enrollments.Source: Tan and Mingat (1992).

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preventive services. This includes an improvement in the water and sanitation sector, assome of those diseases are caused by contaminated food or water.

(b) Higher Allocation to Primary-level Facilities. Higher level facilities have been driving thepriorities of government budgets during the past decade. In fact, most of the increase incurrent expenditure between 1981 and 1991 was allocated to secondary and tertiary facilities.During the period, the allocation to higher level facilities rose from 53 to 80% of totalcurrent expenditure, while that at the primary level fell from 30% to only 13%. Adequatesupply of drugs needs to be ensured by improving drug procurement and distribution systems

(c) Recurrent Budgetarv Implications of Capital Investment. The relative neglect of the recurrentbudget is also of concern; the current budget/capital stock ratio dropped substantially from anaverage of 0.9 in 1975-77 to 0.4 in 1990-92. The inadequate level of spending on repairsand maintenance is of particular concern. According to an internationally accepted norm, anadequate level of expenditure for repairs and maintenance is 1.5% of the value of the existingcapital stock. In recent years, Sri Lanka has been spending only one-fourth of the desiredlevel.

Private Health Services

88. Private health services have been increasing rapidly in recent years, offering both western andtraditional types of medical services to the population. The private expenditures on health representedalmost a half of overall national health expenditures in 1986/87. The recent household surveys in fourdistricts have revealed that about one-third of the persons reporting illness consulted public facilities,another one-third sought care from private providers, and the rest resorted to self-medication.40 However,these private health service providers operate in a virtually unregulated environment. There is a need foran adequate regulatory framework to ensure a minimum level of quality and effectiveness. Given fiscalconstraints, it may also be desirable to review the role of the Government as a health service provider andestablish a balance between the public and private sectors. For example, the Government could placestronger emphasis on preventive care, communicable disease control and health education, while relyingmore on the private sector for curative and tertiary care. Whatever the system, adequate mechanisms haveto be in place to ensure that the poor have access to all necessary treatment and care.

Malnutrition

89. Evidence suggests that a rather high proportion of young children suffer from nutritionaldeficiencies. For example, recent data show that about a third of the children in the critical age group of3-35 months are underweight for their age.4" The most accepted explanation is that poor feedingpractices at weaning is the main cause. The greatest impact will probably be achieved by increased effortsin disseminating information on optimal nutrition practices during this critical period through mass mediaand existing primary care outreach capacity.

40 Government of Sri Lanka, Household Health Survey (1991).

41 Government of Sri Lanka, Demographic and Health Survey (1993).

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V. Reforming the Social Welfare Programs

90. The Government's array of special programs to alleviate the effects of economic misfortunethrough food stamps and income transfers are an important element of Sri Lanka's poverty alleviationstrategy. These programs are especially needed to protect the poor and other vulnerable groups duringperiods of macroeconomic and structural adjustment, as well as political turmoil and violence. However,most of these programs suffer from two interrelated problems. First, they represent a significant burden onthe budget; expenditures on social protection as a ratio to GDP are significantly higher in Sri Lanka than inmore industrialized and higher income countries. For example, in 1992, public spending on social security,welfare and housing in Sri Lanka (4.5% of GNP) was higher than in Mexico (2.3%), Malaysia (3.4%) andThailand (1%). Second, and at the same time, transfer levels to the poorest households are not as high asthey should be. The answer to both these problems is, of course, improved targeting. Hence, afterreviewing quickly the nature and cost of the social transfer programs, the chapter turns to the difficulties intargeting transfers to the poor. It indicates how Sri Lanka is building on past progress in targeting with theintroduction of the Prosperity, or Samurdhi, program.42 Finally, the chapter discusses the possible role ofpoverty alleviation programs to complement the safety-net provided by social transfers.

91. Cost Effectiveness of the Income Transfers Programs. The major social transfer programsand their estimated costs in 1994 were:

(i) Janasaviya, which is a two-year program of intensive transfers accompanied by limitedpoverty-alleviation efforts (Rs 4-5 Billion);

(ii) The food and kerosene stamp program, including infant milk stamps (Rs 2.8 billion);(iii) Emergency food, which is mainly aid to refugees (Rs 2 billion);(iv) The mid-day meal (Rs 1.5 billion);(v) The school uniform program (Rs 600 million);

(vi) Thriposha, a supplementary feeding program (Rs 175 million);(vii) The flour and bread subsidy (Rs I billion and Rs 7 billion in 1995); and

(viii) The fertilizer subsidy (Rs 700 million and 1.2 billion in 1995).

92. The combined expense of the programs severely complicates efforts to reduce publicexpenditures. The social transfers absorbed some 2.9% of GDP in 1994 and, about 3.5% of GDP in 1995.In view of the need to reduce the fiscal deficit, the scope and magnitude of the programs do not seemsustainable. They compromise macroeconomic stability and hence, hinder the growth of private sector andlimit the absorption of some of the poor into private employment. Aware of these trade-offs, theauthorities in the past have reduced costs by allowing inflation to erode the real value of the incometransfers, rather than target benefits to the poorest. As a result, the social transfer programs are not cost-effective in supporting the poor because they transfer relatively modest sums to a large fraction of thepopulation rather than adequate sums to the very poor.

93. Meeting the basic needs of the destitute poor--defined as poor households headed by thedisabled, elderly or widows, and the orphans, elderly, and disabled without means of support should be thenumber one priority of public transfer programs. However, once again because of cost pressures, theprograms that support these destitute poor appear under-funded and in disarray. For instance, the publicassistance program transfers amounts as inadequate as Rs 100 per month to many of the destitute poor;

42 A background paper for this report by Dr. R.M.K. Ratnayake (1995) describes the history of social transfers in Sri

Lanka and current thinking regarding the design of the reformed and consolidated Samurdhi program.

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some elder homes and orphanages receive similar subsidy per inhabitant. Furthermore, newly destitutehouseholds cannot enter the food stamp progran and 50,000 qualified households are on a waiting list toenter the public assistance program.

94. Tareetin! Transfers to the Poor. Sri Lanka has improved targeting over the past 15 yearsalthough there have also been serious set-backs (Box 8). The mid-day meal and school uniform programsare poorly targeted because they provide benefits to every household with school children while thefertilizer subsidy benefits all farmers rich or poor. The wheat flour subsidy is particularly poorly targetedbecause it benefits all consumers and especially the rich. Figure 2 shows the distribution (incidence) of thesubsidy across households, from poorest to richest decile4. Accordingly, the richest 20% of householdsreceive about 32% or Rs 1,600 million of the subsidy while the poorest 20% receive only 9% or Rs 400million. The food stamp program benefits over 40% of the population, including many non-poor butexcludes some of the poorest households. One study showed that households in the top 60% of the incomedistribution received a third of outlays on food stamrps44. The Janasaviya program targets transfers to thepoor more effectively than the other transfer programs but is fiscally expensive.

Box 8:Back to the Future -

Evolution of Targeting of Social Transfers to the Poor in Sri Lanka

In the mid-1970s, the entire population received govemment transfers through the distribution ofrice rations at subsidized prices and through a bread subsidy. In 1978, the rice ration was restrictedto the poorest half of the population.

* In 1979, the rice ration was replaced with the Food Stamp Program, which was distributed to abouthalf of all households.

* In 1989, the Janasaviya Program was introduced. Households were admitted from Food StampProgram roles after passing a screening that excluded many recipients. The screening wasconducted through community meetings and then through inspections of households for assets, suchas consumer durables, that would indicate they are not poor.

* At about the same time, the Govemment introduced the Mid-day Meal, which distributed a lowvalue food stamp to all households with school children, and the distribution to all households ofSchool Uniforms.

* In 1991, an attempt to screen Food Stamp beneficiaries identified about 345,000 beneficiaryhouseholds which did not qualify and 132,000 non-beneficiary households which would qualify.The new qualified households were admitted but the unqualified households were not removed. In1994, about 40% of households received Food Stamps and the purchasing power of the stamps wasdeclined by about 40% since 1979.

* In 1994, general commodity subsidies, (the lowest level of the targeting hierarchy), for fertilizer,and more importantly, flour and bread was re-introduced.

* In 1995, the Govemment consolidated the transfer components of some of the existing programs(Food Stamps, Mid-day Meal and the main Janasaviya) into a single transfer program calledSamurdhi using community based targeting procedures. The transfer of Rs 500-1,000/month is tobenefit 1.2 million households.

95. Hence, there is still much room to advance up the hierarchy of cost-effective targeting so thatadequate support is delivered to the poorest fraction of the population at a fiscally sustainable cost. Thelowest level of the hierarchy is a general food (or other commodity) subsidy; at the next level the subsidy

43 Each decile represents an income group composed of 10% of the population.

44 N. Edirisinghe (1987).

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is limited to foods consumed by the poor or foods that are unattractive to the rich because of their inferiorquality. Food stamps are better targeted than food subsidies because screening methods can be applied tothe list of recipients. Cash transfers to a well-screened list are at the highest level because cash allowshouseholds to purchase what they want most. Cash transfers also allow poor households to choose thestore that gives them the best price-quality ratio. In general terms, the most cost-effective social programsare cash transfers targeted to the poorest quintile of the population and especially to the destitute poor.

Figure 2

Projected Incidence of the Wheat Flour Subsidy in 1995

Rs 893900800 Rs 722700 Rs 659

Rs 5806 600 Rs 515

c..500 Rs 458

400 Rs 346R38

300 Rs 26420-Rs 174E 200 B/ _

1077

v, r rm 0 - - O

Poorest income deciles RichesVtSoume ermus, Houeehold Expenditure Swey & World Hank

96. The Government consolidated, in 1995, the transfer components of some of the existingprograms--including the main Janasaviya, Food Stamps and Mid-day Meal programs--into a single transferprogram called Samurdhi using community based targeting procedures. The Government intends to limitSamurdhi to the poorest 1.2 million households (compared to 1.5 million receiving food stamps). The newprogram has two benefit levels: a higher level for the poorest 100,000 households (Rs. 1000/month), and alower level for other recipients (Rs 500/month). Households are admitted into the consolidated programafter screening; all beneficiaries would be screened periodically and those that had advanced out of povertywould be phased out of the higher level and newly eligible households admitted.

97. Despite these very positive initiatives, there are several other reforms that would improvetargeting and cost-effectiveness of the safety-net programs. Of highest priority is to eliminate theregressive flour subsidy and the fertilizer subsidy, saving some 1-1.5% of GDP on an annual basis. Ifnecessary, the Samurdhi transfer level could be increased to compensate the poorest households. Otherintegrated programs, such as the free school uniforms, could also be phased out unless they can beexplicitly targeted to the poor. Finally, some 400,000 household will continue to receive Janasiviya"interest" payments. They should be screened and integrated into Samurdhi.

98. Screening mechanisms could also be improved in time. Several developing countries havedeveloped practical means of improving targeting (Box 9). In Sri Lanka, the community based screeningdeveloped for the Janasaviya program could be improved by excluding owners of more than I to 1.5hectares of land. The screening to identify the poor might be supplemented by the use of health indicatorssuch as wasting and stunting of children and quality of latrine facilities. A requirement that the non-destitute poor do some physical labor on public works would introduce an element of self-targeting if thewage were set below the average wage for casual agricultural labor.

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Box 9:Successful Targeting of Social Transfers

in Developing Countries

Replacement of general food subsidies in Jordan with subsidies to staples consumed by the poor and withfood stamps successfully targeted the subsidies while reducing the cost from 3.2 to 1.4 percent of GDP.Jordan also introduced a cash transfer to families identified as below the poverty line.

* Public works employment programs in Maharahtra State in India and in Chile provided an effectivesafety-net for the poor as wages were kept low so that the jobs would not be attractive to the non-poor.

* Nutrition and health programs aimed at the ultra-poor and especially at poor women and children haveproved more effective than food subsidies in supporting the poor in Chile, Mexico, and Costa Rica. InBangladesh, the Vulnerable Group Development program serves the ultra-poor through supplementaryfeeding. In Malawi, a major feeding program implemented through hospitals and clinics successfullytargeted malnourished children.

* Non-Povernmental micro-credit schemes such as the Grameen Bank in Bangladesh provide an incomegenerating route out of poverty as an alternative to transfers. Several of these schemes have created awell targeted safety-net for many vulnerable households and especially for poor women.

99. Poverty Alleviation. Social transfers cannot be a permanent response to poverty except forthe part of the destitute population that is unable to participate in the economy. As noted above, lastingand rapid declines in poverty require broad based, high and sustained growth. Participation in governmentor non-governmental special poverty alleviation programs may also help, although the record is mixed. Forinstance, the Janasaviya program was designed as a poverty alleviation rather than a transfer program.However, it proved difficult to organize its poverty alleviation components, such as public works andtraining, or to enforce its labor requirement. Unfortunately, there is no evidence that the programsustainably lifted many of the poor out of poverty. However, there do appear to have been creative ideasin the design of the Janasaviya program that would have been worth testing in several divisions at a modestcost.

100. The lesson appears to be that new poverty alleviation programs should be tested on a smallscale so that the costs are not fiscally burdensome and so that there is an opportunity to learn frommistakes. Many of the ideas proposed for the poverty alleviation side of the Samurdhi program arepotentially valuable but should be started on a small scale to avoid the mistakes made with the mainJanasaviya program.

IV. Sri Lanka's Economic Growth

101. Rapid economic growth, expanding job and income opportunities, and permanent reduction ofpoverty are well within Sri Lanka's reach. It already has a strong foundation, with its deep human capitalbase, its outward orientation, and the economic momentum of the early 1 990s. However, peace is essentialto fully realizing its potential. So is moving forward, quickly and steadily, with the reform agenda --described above -- that encompasses macroeconomic stability, redefining the role of the state, andincreasing private activity and investment. Finally, further investments in its people are needed to maintain

- 37 -

its edge in human development and meet the requirements of a modernizing economy. As the Governmentgradually and successfully completes the reform agenda, economic performance should improvesignificantly (see details in Annex). With rising private investment (to 22% of GDP), GDP growth couldincrease to some 7% p.a by the year 2000. Improved agricultural performance, responding to the reform ofland and incentive policies, would complement the growth of manufacturing and tourism and otherservices. If peace is fully consolidated, Sri Lanka's potential growth rates are likely to be higher, in theorder of 8%-9% p.a., and could rise even further during the period of reconstruction of the North and East.

102. Together with the improvement in the quality and delivery of social services, as well as bettertargeted safety nets, these high growth rates would make a significant dent on poverty over the medium-term. The rate of unemployment could well decline to about 5-6% by the year 2000, achieving one of theGovernment's key social objectives. In terms of consumption poverty, per-capita private consumptionwould expand in real terms during the adjustment period at some 2%-3% p.a., later rising to some 4%-5%p.a. By the year 2004, real private consumption would have almost doubled compared to 1993.

103. Hence, by the year 2000, the Government could be well on the path of achieving its vision ofproviding jobs and opportunities to all and eradicating poverty. By meeting the challenges of peace andreform, Sri Lanka could replicate the growth rates achieved by its East Asian neighbors withoutcompromising its deep commitment to social development and equity. Postponing reform will make itimpossible to meet the aspirations of its people and will condemn Sri Lanka to a bleaker economic fortunethan is warranted.

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ANNEX

Medium-Term Outlook Under Adjustment

1 04. This annex will describe in broad terms how the economy is likely to perform over the nextfive to ten years. Overall, given its deep human capital base and the economy's positive momentumresulting from the adjustment efforts undertaken in the early 1990s, Sri Lanka's growth potential is strong.However. this potential can only be realized under certain key assumptions.

105. Assumptions and Policy Environment. First, the international environment is expected tobe particularly favorable over the next five years; forecasts indicate solid world growth, no major terms oftrade shocks, and moderate world interest rates. However, while this is good news, Sri Lanka is not overlyexposed to external shocks. Much more important are two assumptions relating to internal events. SriLanka's growth prospects depend critically on whether the Government implements forcefully and in atimely manner a reform program along the lines described in this report. Peace is the second necessaryingredient for Sri Lanka to fulfill its strong growth potential.

106. Peace. Peace is essential to restore the productive capacity of the North and East, sustainprivate confidence. fully exploit tourist potential, and help reduce macroeconomic imbalances and releaseresources towards productive uses. Given the current status of the conflict, it is difficult to predict whenpeace will be achieved. HIowever, the Government is strongly committed to a negotiated solution to thewar. including devolution of power to regions and safeguarding the rights of minorities. Hence, theprojections assume that the intensity of the war declines sharply but that full peace is not achieved duringthe projections period. Under these improving circumstances, it would be possible to reap a substantialproportion of the benefits enumerated above, but not all.

107. Key Reform Efforts. While these peace efforts are critical, the Government also needs toresume adjustment and structural reform. The required efforts have been described in the report and areonly recapped here.

* IiMacroeconomic stability. The key is to reduce the fiscal deficit from around 10% in1995 to around 3%-4% by early next century, mainly by expenditure restraint. Fiscal policy will becomplemented with a flexible exchange rate policy and a prudent monetary policy directed at maintainingexternal competitiveness and reducing inflationary pressures.

* Redefining the Role of the State. The State needs to be more effective as a provider ofpublic goods and services, and as a regulator and policy maker. This means administrative reform, andcurtailing activities as a producer of private goods and services (including infrastructure) and as anemployer of last resort. This also means increasing transparency.

* Increasing Private Activity and Investment. The improvements of the early 1990s in theenabling environment for private investment need to be deepened. This is a wide ranging area, includingtax and trade policy and financial sector reform, and updating labor legislation and other aspects of thelegal framework. Additionally, increasing the role of the private sector in the plantation subsector andrevamping the incentive and land-tenure systems would help improve lagging agricultural performance.

* Human Resource Development. To maintain its edge in human development and meet theneeds of a modernizing economy, a medium-term challenge is to improve quality in the delivery of basic

- 39 -

education and health services. In primary and secondary education, the priority is to implement a rationalteacher hiring and deployment policy, emphasizing training and quality inputs rather than new hirings ofuntrained graduates. In health the priority is to reallocate resources to primary and preventive healthfacilities.

108. The Adjustment Period. Responding to these adjustment measures, Sri Lanka'seconomic performance should improve gradually over the period 1996-98 (Table 2). Growth should riseto about 6%-6.5% p.a. by 1998, driven, as in the recent past, by manufacturing, especially tradeable goods,and tourism services. Exports and investment will continue to be the main sources of growth on thedemand side, as their growth rates recover to the levels achieved in the early 1 990s. Private investment inparticular should recover strongly, as confidence is restored with improved economic management and thedwindling war. Private investment should also respond favorably to the sharp drop in budgetary financingrequirements and, hence, less crowding out.

Table 4: Key Economic Indicators under Adjustment

Estim. Projections a/1994 1995 1996-98 1999-01 2002-04

Output and pricesGDP real growth rate 5.6 5.5 5.8 7.0 7.0GDP deflator 9.7 9.5 7.7 6.3 6.0

Investment and Savings (% of GDP)Gross domestic investment 27.0 26.0 27.0 29.2 30.4

Gross private investment 20.0 18.4 19.0 21.0 22.1Gross public investment 7.0 7.6 7.9 8.2 8.3

Gross national saving 19.1 17.8 21.0 24.0 26.2Government saving -3.2 -2.1 1.1 4.4 5.8Private saving 22.3 19.9 19.9 19.7 20.3

Government Budget (% of GDP)Total revenue 19.0 20.5 20.9 20.8 21.3Total expenditures (incl. net-lending) 29.0 30.8 27.0 24.6 23.7Overall balance (excl. grants) -10.0 -10.3 -6.1 -3.9 -2.4Financing in domestic borrowing 6.5 5.4 2.9 1.1 0.4

External sectorExports real growth b/ 9.9 8.8 9.4 9.5 9.5Imports real growth b/ 15.9 2.7 7.6 7.8 8.5Current account balance/GDP (%) c/ -7.9 -7.9 -5.9 -5.2 -4.2

a/ Annual average.b/ Goods and non-factor services in million of US$.c/ Excluding official grants.Source: Central Bank of Sri Lanka and World Bank staff estimates.

109. Sri Lanka's external accounts should also respond to the adjustment measures. Goodexport performance andcthe fiscal adjustment should bring about a strong increase in national savings and adecline in the external current account balance to about 5%-6% of GDP. The capital account would alsostrengthen as private capital flows respond to the boost in private confidence and investment.

- 40 -

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