Nature of the Economy

Sri Lanka Table of Contents

Sri Lanka's economic prospects in early 1988 were linked at least in part to the political and security situation. If political violence could be brought under control, the government had commitments from foreign investors and donors to finance a reconstruction program that would ensure economic growth in the short term. If the violence were to continue, the diversion of resources into defense and the negative impact on tourism and foreign investment appeared likely to result in economic stagnation.

Structure of the Economy

Agriculture, both subsistence and commercial, has played a dominant role in Sri Lanka's economy for many centuries. The Portuguese and Dutch, who ruled the coastal regions of the island from the sixteenth through the eighteenth centuries, were primarily interested in profiting from cinnamon and other spices. Trade with India, Sri Lanka's nearest neighbor, was also important during this period. Sri Lanka exported pearls, areca nuts, shells, elephants, and coconuts, and in return received rice and textiles.

The island's economy began to assume its modern form in the 1830s and 1840s, when coffee plantations were established in the Central Highlands. Coffee soon became the dominant force in the economy, its proceeds paying for increasingly large imports of food, especially rice. When coffee fell victim to a leaf disease in the 1870s, it was quickly replaced by tea, which soon covered more land than had coffee at its height. Coconut plantations also expanded rapidly in the late nineteenth century, followed by rubber, another cash crop introduced in the 1890s. Stimulated by demand generated by the development of the automobile industry in Western Europe and North America, rubber soon passed coconuts in importance. These three products--tea, coconuts, and rubber-- provided the export earnings that enabled Sri Lanka to import food, textiles, and other consumer goods in the first half of the twentieth century. At independence in 1948, they generated over 90 percent of export proceeds.

Wet rice was grown extensively as a subsistence crop throughout the colonial period. In the nineteenth century, most of it was consumed in the villages where it was grown, but in the final decades of British rule the internal market in rice expanded. Nonetheless, more than half of the rice consumed was imported, and the island depended on the proceeds of plantation crops for its food supply.

The economy gradually became more diverse after the late 1950s, partly as a result of government policies that encouraged this trend. The main reason successive administrations tried to reduce the country's dependence on tea, rubber, and coconuts was the long-term decline in their value relative to the cost of imports. Even when Sri Lanka increased the production of its major cash crops, the amount of imports that could be bought with their proceeds declined.

Much of the diversification of the economy, especially in the 1960s and the early 1970s, took the form of import substitution, producing for the local market goods that the island could no longer afford to import. Sri Lanka also had some success in diversifying exports after 1970. The proportion of exports linked to the three traditional cash crops fell from over 90 percent in the late 1960s to 71 percent in 1974 and 42 percent in 1986. Textiles, which made up only 0.7 percent of exports in 1974, accounted for over 28 percent in 1986.

In 1986 agriculture, forestry, and fishing made up 27.7 percent of the gross national product (GNP), down from 39.4 percent in 1975. In 1956 wholesale and retail trade accounted for 19.9 percent of GNP, and manufacturing for 15.6 percent. Transport, storage, and communications stood at 11.2 percent of GNP, and construction at 7.7 percent. The relative importance of the various sectors of the economy was fairly stable during the 1980s.

Role of Government

The role of government in the economy during the final decades of British colonial rule was considerable. The plantation economy required extensive infrastructure; the colonial state developed and owned railroad, electrical, postal, telegraphic, telephone, and water supply services. Quasi-state financial institutions served the colony's commercial needs, and during World War II the government set up production units for plywood, quinine, drugs, leather, coir, paper, ceramics, acetic acid, glass, and steel. Welfare policies also began during colonial rule, including a network for free and subsidized rice and flour established in 1942. Free education, relief for the poor, and subsidized medical care were introduced in the late British period. Moreover, after 1935 the government took an active role in the planning and subsidizing of colonization schemes. This policy was designed to remove landless peasants from heavily populated areas to newly irrigated tracts in the dry zone.

Economic policy since Independence is divided into two periods. During the first, which lasted from 1948 to 1977, government intervention was often seen as the solution to economic problems. The expansion of government participation in the economy was fairly steady, resulting in a tightly regulated system. This trend was especially marked during the period of S.R.D. Bandaranaike's second government, from 1970 to 1977, when the state came to dominate international trade and payments; the plantation, financial, and industrial manufacturing sectors; and the major trade unions outside the plantation sector. It also played a major role in the domestic wholesale and retail trade.

The trend toward greater government involvement was largely a response to the deteriorating terms of trade. The plantation economy had financed social programs such as subsidized food in the late colonial period, but when the value of exports declined after 1957, the economy's capacity to support these programs was strained. When the foreign exchange reserves of the early 1950s dwindled, import-substituting industrialization was seen as a solution. Because the private sector viewed industrial development as risky, the government took up the slack. When balance of payment deficits became chronic, some nationalizations were justified by the need to stem the drain of foreign exchange. Similar concerns led to the tighter regulation of private business and the establishment of state-owned trading corporations. When there were shortages of necessities, governments expanded state control over their distribution in order to make them available at low prices.

The 1977 elections were largely a referendum on the perceived failures of the closed economy. The UNP, which supported a deregulated, open economy, won decisively. The new government rejected the economic policies that had evolved over the previous twenty years. Some observers believed that the economy had been shackled by excessive regulation, an excess of consumption expenditure over investment, and wasteful state enterprises. Under the UNP, market forces were to play a greater role in allocating resources, and state enterprises were to compete with the private sector.

The main elements of the new policy were investment incentives for foreign and domestic capital, a shift in the composition of public spending from subsidies to infrastructure investment, and a liberalized international trade policy designed to encourage export-led growth. Employment creation was a central objective, both through encouragement of domestic and foreign capital investment, and through an ambitious public works program, including the Accelerated Mahaweli Program, which aimed to bring new land under irrigation and substantially increase hydroelectric generating capacity. Two other policies that sought to create employment were the establishment of investment promotion zones (free trade zones) and extensive government investment in housing.

The role of government during the decade after 1977 remained significant; the public investment program, for instance, was implemented on a greater scale than anything attempted previously, and in early 1988 the state remained heavily involved in many areas of economic activity. But while the government increased its efforts to develop the nation's infrastructure, it reduced its role in regulation, commerce, and production. Its initiatives received the enthusiastic support of the international development community. As a result, Sri Lanka received generous amounts of foreign aid to finance its post-1977 development program. This foreign assistance was integral to the government's economic strategy. Because budget deficits were large even before 1977, external financial resources were necessary to pay for the increased spending on infrastructure and to make up for the revenue lost as a result of the tax incentives given business. Similarly, relaxing import controls put pressure on the balance of payments, which could be relieved only with the help of foreign aid.

Development Planning

During the early years of independence, successive governments placed little emphasis on development planning, in part because the immediate economic problems appeared to be manageable. The National Planning Council was established in 1956 as part of the Ministry of Finance. Between 1957 and 1959, the council and the Central Bank of Sri Lanka invited a number of foreign economists to visit Sri Lanka and offer the government both their diagnoses of the country's economic problems and their prescriptions for the planning and implementation of recommended remedies. These studies provided many of the rationales for economic policies and planning in the 1960s.

In 1959 the National Planning Council issued a Ten-Year Plan, the most ambitious analysis of the economy and projection of planning that had yet been officially published. This plan sought to increase the role of industry in the economy. Unfortunately, its forecasts were based on faulty projections of population and labor force growth rates. Moreover, attempts to implement it collided with the exchange and price crunch of 1961 and 1962, and the plan became increasingly out of touch with the changing economic situation.

A new Ministry of Planning and Economic Affairs (no longer in existence) was established in 1965. The ministry decided not to draft another single long-term plan involving a five- or ten-year period. Instead, it drew up a number of separate, detailed, well-integrated, five-year plans involving different ministries. The government targeted agriculture, especially wet rice, as the area in which growth could best be achieved.

The UNP government that came to power in 1970 shifted toward a more formal and comprehensive state direction of the economy. The Five-Year Plan for 1972-76 had two principal aspects. First, it sought to remove disparities in incomes and living standards. Second, the plan sought to promote economic growth and to reduce unemployment. It envisioned rapid growth in agriculture, not only in the traditional crops of wet rice, tea, rubber, and coconut, but in such minor crops as sunflower, manioc, cotton, cashew, pineapple, and cocoa. Like the Ten-Year Plan of 1959, this plan proved to be based on overly optimistic assumptions, and it soon ceased to exercise influence on the government's economic policy. In 1975 it was replaced by a Two-Year Plan that placed even greater emphasis on agricultural growth and less on industrial development.

After 1977 the government continued to accept the principle of state direction of economic activity, but in contrast to the 1970-77 period the government encouraged the private sector to participate in the economy. Its first Five-Year Plan (1978-83) included an ambitious public investment program to be financed largely by overseas grants and loans. Its immediate objective was to reduce unemployment, which had risen during the tenure of the previous government.

A series of five-year rolling investment plans was set in motion by the Ministry of Finance and Planning in the 1980s. The plan for the 1986-90 period envisaged investment of Rs268 billion with the emphasis on infrastructure projects such as roads, irrigation, ports, airports, telecommunications, and plantations. Of this total, 50 percent was to be spent by the state sector. Foreign sources were to supply Rs69 billion. The target annual average growth for the gross domestic product (GDP) was 4.5 percent, a decrease from the 5.2 percent envisaged by the plan for the 1985-89 period and the 6 percent actually achieved between 1977 and 1984.

The Economy in the Late 1980s

Growth in GDP was estimated at 3 percent in 1987, down from 4.3 percent in 1986, and the lowest level in a decade. By 1987 it was clear that the ongoing civil unrest was causing serious economic difficulties, mainly because rapidly increasing defense outlays forced the government to cut back capital expenditure and to run a large budgetary deficit. Concern over the decline in foreign investment and extensive damage to infrastructure mounted as sectors such as tourism, transportation, and wet rice farming suffered production losses directly related to the decline in security.

By early 1988, the ethnic conflict had resulted in extensive property damage. Infrastructure damage in Northern and Eastern provinces was estimated at Rs7.5 billion in August 1987 and was expected to be revised upwards to include the widespread destruction in the Jaffna Peninsula. In the predominantly Sinhalese areas, riots against the 1987 Indo-Sri Lankan Accord caused damage to government property estimated at Rs4.8 billion.

In early 1988, future economic prospects were closely linked to the security situation. Late the previous year, the government succeeded in obtaining commitments from foreign nations and international organizations to finance an extensive reconstruction program for the 1988-90 period. If there were a pronounced ebb in the political violence plaguing the island nation, it would be probable that the official target of Rs80 billion foreign aid over this three-year period would be reached. Aid on this scale, which would be a substantial increase on the already generous levels received, would not only enable the rebuilding of infrastructure destroyed by the violence but also fuel growth and allow the large trade and budget deficits to continue. Accordingly, the 1988 budget foresaw a sharp decline in defense spending and an increase in capital expenditure. These economic plans, however, depended on a peaceful solution to the country's political problems. If political violence escalated in subsequent years, not only would the government have to shift its spending back to defense, but some of the expected foreign aid probably would be suspended.

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Source: U.S. Library of Congress