Sri Lanka - A fresh look at unemployment

Report No 19609-CE Sri Lanka A Fresh Look at Unemployment August 10, 1999 Poverty Reduction ancl Economic Management Unit South Asoa Re Wion Document of tile World Bank  CURRENCY EQUIVALENTS Sri Lankan Rupee (SLR) US $1.00 = SLR 71.52 (July 23, 1999) FISCAL YEAR (FY) July 1- June 30 ABBREVIATIONS AND ACRONYMS A/LEVEL Advanced Level Examination BOI Board of Investment CPC Ceylon Petroleum Corporation CSPS Civil Servants' Pensions Scheme DCS Department of Census and Statistics EPF Employees' Provident Trust EPZ Export Processing Zone ETF Employees' Trust Fund GCEC Greater Colombo Economic Commission ILO International Labor Organization LFS Labor Force Survey OECD Organization for Economic Cooperation and Development O/LEVEL Ordinary Level Examination OLS Ordinary Least Squares TEWA Termination of Employment and Workmen Act WTO World Trade Organization Vice President: Mieko Nishimizu Country Director: Mariana Todorova Sector Manager: Roberto N. Zagha Task Leader: Eric Bell  TABLE OF CONTENTS EXECUTIVE SUMMARY ........................................................................lI CHAPTER 1: MACROECONOMIC BACKGROUND AND SECTORAL CHANGES IN THE ECONOMY .........................................................................1 A. MACROECONOMIC CHANGES AND PERFORMANCE .... ........ ......................................................1 B. IMPACT OF ECONOMIC TRANSITION ON UNEMPLOYMENT .................................................................I C. KEY FEATURES OF THE UNEMPLOYMENT SITUATION ........................................................................2 CHAPTER 2:. THE UNEMPLOYMENT PUZZLE- PREVIOUS RESEARCH ................................3 A. A REVIEW OF PREVAILING HYPOTHESES .............. ..........................................................3 B. SHORTCOMINGS IN EXISTING WORK .........................................................................4 CHAPTER 3: CURRENT STUDY- NEW DATA AND METHODOLOGY ......................................5 A. DATA .........................................................................5 B. METHODOLOGY .........................................................................5 CHAPTER 4: ECONOMETRIC ANALYSIS AND ITS FINDINGS ......................... ...........................7 A. STRONG JOB PREFERENCES PARTLY EXPLAIN THE UNEMPLOYMENT CONUNDRUM . 7 B . LTnTLE EVIDENCE OF A SKILLS MISMATCH EXPLANATION FOR UNEMPLOYMENT . 9 C. LABOR MARKET SEGMENTATION PROVIDES AN INCENTIVE FOR UNEMPLOYED YOUT TO WAIT FOR "GOOD" JOBS .11 D. UNEMPLOYMENT HAS No IMPACT ON INFORMAL SECTOR WAGES .13 CHAPTER 5: FITTING THE PUZZLE- THE ROLE OF THE POLICY ENVIRONMENT ....... 15 A. OVERVIEW ....................................................................... 15 B. LABOR MARKET REGULATION CONSTRAINS THE CREATION OF "GOOD" JOBS ................................ 15 C. SKEWED DEMAND FOR PROTECTED FORMAL SECTOR JOBS ............................................................ 18 D. GOVERNMENT'S RESPONSE TO THE LABOR MARKET SITUATION ......................... ........................... 20 CHAPTER 6: SUMMARY AND REFORM AGENDA ......................................... 26 A. SUMMARY OF ANALYSIS ......................................... 26 B. REFORM AGENDA ......................................... 26 TECHNICAL ANNEX .......................................... 31 BIBLIOGRAPHY ......................................... 45 List of Boxes, Figures and Tables Boxes Box 5.1: Costs of Protection- the Case of the Banking Sector .................................................. 17 Box 5.2: Accessing the Formal Private Sector: Inadequacies of the Education System .............. 19 Box 5.3: Equal Access to Education = Equal Access to Employment? ........................................ 21 Box 5.4: Youth Discontent and Unemployment ............................................................. 25 Box 6.1: International Experience on Labor Markets ............................................................. 28 Box 6.2: Labor Market Reforms- the Latin American Experience ............................................ 29  Figures Figure 1.1 GDP Growth and Unemployment Rates, 1971-98 .....................................................1 Figure 1.2 Labor Force participation Rate, 1971-98 ......................................................1 Figure 1.3 Unemployment Rate by Sex and Age, 1998 ...................................................... 2 Figure 1.4 Unemployment Rate by Level of Education, 1998 ....................................2................2 Figure 5.1 Real Wage Index in Informal Sector, 1980-97 ..................................................... 18 Figure 5.2 Annual Flow of Foreign Employment by Skill Level, 1988-98 ................. ............. 22 Tables Table 4.1 Unemployment Rates by Age, Education and Household Status .................... 7 .........7 Table 4.2 Deterrminants of Unemployment ......................................................8 Table 4.3 Lowest Acceptable Wage over Average Wage by Education ................................. 10 Table 4.4 Determinants of Actual and Reservation Wages (All Country) ......................... .10 Table 4.5 Determinants of Labor Earnings by Broad Categories ............................................ 12 Table 4.6 Determinants of Labor Earnings by Education Level ............................................. 13 Table 5.1 Number of Firms in the Rural Area by Selected Industries and Size, 1995 ..................................................... 17 Table 5.2 Employment by Sector, 1988-98 ..................................... 21 Table 5.3 Total Government Employment, 1988-98 ..................................... 23 Table 5.4 Size of the Public Sector in Asia ..................................... 23 Table 5.5 - Salary Structure of Public and Provincial Public Service (entry level grade) ............. ...... ................ .. 24 This report was prepared by Eric Bell (Task Leader, SASPR), Rapti Goonesekere (SASPR), and Martin Rama (DECRG). Donald Mitchell (DECPG) and Geeta Sethi (SASRD) provided contributions on the rural labor market. Research assistance was provided by Princess Ventura (SASPR) and Yvonne Ying (Consultant). Team assistance was provided by Jennifer Manghinang (SASPR). Peer reviewers were Amit Dar (HDNSP) and Chandra Rodrigo (University of Colombo).  EXECUTIVE SUMMARY 1. Unemployment has historically been a very sensitive issue in Sri Lanka. This is due to the fact that high levels of unemployment have predominantly been concentrated among educated youth- a group which has proven to be socially and politically volatile in the past. The Marxist youth insurrection of 1971, inspired by the Guevarista movement in Latin America, raised its head in an even more virulent manner to bring Sri Lanka to a virtual standstill during 1987-89. All forms of governance and law and order were crippled during this time, resulting in a near state of anarchy. Several thousands were reported to have lost their lives or disappeared during this period. The rebellion was led by mostly disadvantaged youth from rural areas of the country, especially the Southern province where unemployment has traditionally been highest.' Youth unrest was also a contributory factor in the Northern secessionist conflict which began in the early 1980s and continues to date. Memories of these two insurrections, as well as the traumas of the on-going conflict continue to haunt the people of Sri Lanka, thus making the issue of youth unemployment a serious concern for civil society and policymakers. 2. Sri Lanka's economy has grown healthily at an average of 5 percent over the last two decades, and unemployment has declined gradually to 9.5 percent in 1998. This decline, which took place despite a rapid increase in female labor force participation, is the result of sustained economic growth mostly in the private sector following a significant reform of the economy. The most effective of these reforms was the liberalization of the foreign exchange market and trade regime. In addition, Sri Lanka has seen a large increase in outward labor migration since the late 1980s, with the result that expatriate Sri Lankan workers (mostly in the Middle East) account for about 10 percent of the country's labor force. Notwithstanding these positive elements, the persistence of double digit unemployment rates over almost three decades implies that the overall labor market is not functioning at full efficiency. Table A: A Snavshot of Sri Lanka's Labor Market in 1998 Levels Rates (in thnnsands (iln nereentl Population 18,774 growth: 1.2 Labor Force 6,693 participation rate: 51.5 Female participation rate: 36.2 Unemployment 607 unemployment rate: 9.5 Female unemployment rate: 14.7 Note: Labor force data excludes the Northeast province. Source: Department of Census and Statistics. 3. Previous research. The persistence of double-digit unemployment in Sri Lanka hat puzzled researchers, policymakers, and the international community for several years. As a result, there is no dearth of research and literature on the topic, and several explanations have been proposed for Sri Lanka's high unemployment. The most important hypotheses developed in the literature are: (i) the prevalence of a skills mismatch due in particular to the education system not being geared to labor market needs (Seers, 1971); (ii) the likelihood that government employment and pay policies promote "queuing" for attractive jobs (Glewwe, 1987; Dickens and Lang, 1996); and (iii) the existence of stringent labor market regulations which discourage job creation (Rama, 1994; Prywes, 1995; Kelegama and Gunatilaka, 1996). The demographic A Presidential Commission on Youth was established in 1990 to examnine the causes of youth unrest and discontent. See Box 5.4 for a summary of findings of the Comuission. i  changes arising from a population bulge between 1950-70 is also cited as a reason for high youth unemployment in the last three decades (Alailima, 1992). 4. Objective of study and methodology. Although plausible, these explanations did not have the benefit of more recent microeconomic data available on household earnings. Hence, the primary objective of this study is to further explore the reasons for the high level of youth unemployment in Sri Lanka using individual records from the 1995 Labor Force Survey (LFS) conducted by the Department of Census and Statistics (DCS). In particular, the study will test the three main hypotheses already presented in the literature by conducting rigorous econometric analysis using the large volume of microeconomic data available from the quarterly Labor Force Survey. The data are analyzed through a comprehensive econometric exercise using multi- variate and probit regressions on unemployment status, earnings functions which control for individual and job characteristics, and by carrying out time series analysis of unemployment and wages between 1980-97. 5. Chapters I and 2 provide background information on Sri Lanka's economic reforms and performance over the last decade, and summarize the conclusions of existing literature on unemployment in Sri Lanka. Chapter 3 presents the new data and methodology used in this study, while Chapter 4 discusses the findings. Chapter 5 explains the results obtained from the data analysis from a broader public policy perspective, and Chapter 6 presents some reform options which could have positive impacts on the labor market in Sri Lanka. 6. Four key findings emerge from the data analysis: * Strong job preferences partly explain the unemployment conundrum. When using a narrow definition of unemployment where only those reported as willing to take "any job" (full-time, part-time, self-employment, or other) are considered unemployed, the overall unemployment rate falls dramatically to 3.2 percent on an aggregate basis. In addition, unemployment appears closely related to household status and the availability of income support from family relatives, both critical factors in encouraging extended periods of job search. a There is little evidence of a theoretical skills mismatch to explain Sri Lanka's unemployment rate. Two statistical techniques have been used to assess the role of education in determining both actual wages for the employed and lowest acceptable wages for those unemployed with similar characteristics. Both techniques show that (i) wages do rise with increasing educational accomplishment; and (ii) the ratio between the lowest acceptable wage of the unemployed and the actual labor earnings of employed individuals with similar characteristics declines with rising educational attainment. These two results cast doubt on the existence of a "theoretical" skills mismatch in Sri Lanka. This conclusion does not invalidate the fact that some of the unemployed do not have the skills most commonly required by currently available jobs. This form of "functional" mismatch in fact persists because of structural obstacles such as wage rigidities and government's employment and pay policies. * There is substantial evidence of labor market segmentation in Sri Lanka which provides a rationale for the unemployed to wait for good jobs. The analysis shows that even on the basis of pure cash wages, public sector jobs are on average more lucrative than non-public sector jobs, at times demonstrating earnings gaps as large as 60-100 percent. These wage ii  gaps are especially evident for workers at lower-levels (primarily those with basic education). There are also substantial earnings gaps in favor of those who are covered by the country's job security regulation (Termination of Employment of Workmen Act- TEWA) and protective tariffs. * Additional evidence of labor market segmentation comes from the data on wage trends in both the formal and infonnal sectors. A time series analysis has been conducted on average wages set by Wages Boards (formal wages) and the average wages of casual workers (informal sector wages) to evaluate the relationship between unemployment and wages in both the formal and informal sectors. The main conclusion is that unemployment rates have no effect on informal sector wages, but do however exert a downward pressure on formal sector wages. This suggests that the unemployed are in search of good formal sector jobs and are not interested in jobs in the informal sector. 7. Labor market segmentation and the policy/social environment. The large wage differentials existing in Sri Lanka (due mostly to labor market segmentation) are artificial, and stem from a policy environment that provides protection to certain segments of the economy in the form of stringent job security regulations, tariffs, and preferential employment and pay treatment in the public sector. Labor market regulations in Sri Lanka are very restrictive, best demonstrated by the costly and non-transparent processes of termination in the formal private sector. In addition to the termination costs, enterprises in the formal private sector also face substantial costs in the form of higher wages (relative to the informal sector), large contributions for retirement income, and the management of militant trade unions that take adversarial positions often based on political agendas. Combined with the fact that the informal labor market appears to operate efficiently, this gives informal sector enterprises little incentive to graduate to the formal sector. As a result, the supply of fornal sector jobs is constrained, while the economy is unable to realize its maximum productivity. 8. The problems resulting from the supply-side shortage of formal protected jobs are compounded by the high demand for this type of job in the economy. School graduates engage in long periods of job search to meet their aspirations for a protected job. Extended job searches are easily sustained given the provision of free education at all levels and the availability of income support from family and relatives. Under these circumstances, there is an imbalance between the demand and supply of formal sector jobs in Sri Lanka. 9. Policy response of government. Some of the pressures from unemployment have been eased by the creation of Export Processing Zones (EPZs) and Board of Investment (BOI) companies as well as promotion of large scale outward migration. In the case of EPZIBOI industries, employment generation is due not only to the tax concessions offered, but also the relief afforded them with regard to labor regulations. Unfortunately however, neither the creation of BOI industries nor the promotion of migration has succeeded in addressing the real bottleneck in the labor market, i.e., high unemployment among the educated youth. A large number of BOI jobs are considered "undesirable" by this group, leading to numerous vacancies in the sector. In this context, Sri Lankan governments have regularly resorted to the ad hoc creation of jobs in the public sector to satisfy educated youth. These have been particularly large in the teaching corps, public enterprises, and the operation of poverty programs. 10. The Government's behavior as an employer of last resort is not unique to Sri Lanka. What is unusual, however, is that in addition to artificially creating jobs within government, cash iii  wages paid to public sector employees with A/Level qualifications and below are significantly higher than wages paid to similar workers outside the public sector. In fact, of all protected workers, public sector employees benefit from the largest wage premium. This is somewhat of an anomaly given that public sector employment also entails job security and nonwage benefits such as pensions. The pay distortion is particularly large for non-professionals (support staff) within government administration. Moreover, the Government's existing pay policies have resulted in a highly compressed pay schedule, which has reduced its ability to attract and retain mid- and high-level employees. As a result, Sri Lanka's public sector now faces growing weaknesses in governance and public sector management. 11. Challenges for the future. The most important challenge for Sri Lanka in the area of labor markets is to improve the supply of formal private sector jobs by facilitating the transition of small enterprises operating in the informal sector into larger enterprises operating in the formal sector. The three areas in need of reformn to help this transition are (i) trade and market liberalization; (ii) liberalization of labor regulations; and (iii) reform of public sector pay and employment policies. From a broader perspective however, easy labor mobility into the private sector will also require improvements in the education system with a view to better equip new generations of workers with skills more consistent with market realities. 12. Trade liberalization is the least controversial reform option and one that the Government has already been embracing. Considerable success has also been achieved in developing the domestic competitive environment-- the privatization of Sri Lanka Telecom and tea plantations being good examples. Numerous opportunities remain however with respect to the large statutory boards/public enterprise sector, and private sector participation in infrastructure development. As there has been considerable liberalization of product markets, the most urgently needed reforms are in factor markets. Liberalization of the financial sector is an obvious priority, but equally important is the labor market. Sri Lanka continues to have one of the most restrictive labor market regimes in the developing world, and labor regulations have not evolved in consonance with the broad economic reforms of the last two decades. Consequently, the promotion of BOI industries as well as labor migration have represented in Sri Lanka indirect ways of alleviating the negative fallouts of labor regulations and practices. A better approach would be to ensure that labor regulations provide job and income security to employees without penalizing employers and constraining the private sector's ability to create good jobs. This implies a moreflexible, expeditious and transparent separation regime similar to that of rniddle income countries, the ranks of which Sri Lanka has just joined. 13. Another critical area for reform pertains to the public sector's employment and pay policies. Given the long record established regarding political interference in the management of the public sector, the most effective option is to implement a program of public administration reform that addresses the most egregious governance weaknesses of the sector in a comprehensive way. This would necessarily include institutional modernization, the introduction of mechanisms to mninimize political interference, and the strengthening of financial control and accountability. But these would not suffice without reform of the public sector's salary structure. Clearly, current policies are very taxing on the performance of both government administration and the private sector, and wages need to be adjusted at both ends to ensure consistency with market realities. Non-wage benefits in the public sector are also in need of adjustment. Civil service pensions are generous, while the mandatory retirement income scheme covering the formal private sector is poorly enforced and suffers from negative returns. A higher return on these funds, through financial sector liberalization/development and reduced budgetary needs, iv  would undoubtedly facilitate the needed readjustment as well as increase the mobility between the government and private sectors. 14. Reaching consensus for sustainable reforms. Given Sri Lanka's circumstances, the most critical prerequisite for the success of these challenging public policy reforms is the development of domestic consensus. As in successful reformns in the past, the key ingredient is full participation of all stakeholders in the design of strategies at an early stage. The Government's continued pandering to the demands of protected workers comes at the high cost of marginalizing the large number of workers currently employed in Sri Lanka's informal sector. This was highlighted by the Presidential Commission on Youth, established in 1990 to examine the causes of youth unrest and discontent in the aftermath of the 1987-89 Marxist insurrection. The Commission noted that "a pervasive sense of injustice... arising principally from political patronage in employment" was a fundamental reason for the youth rebellion. Accordingly, "the denial of merit has had a traumatic effect on the youth of the country who...appear to have harbored covert expectations of the dismantling of what they perceived as an inequitable system." A "do nothing scenario" or continued politicized recruitment into the public sector could therefore be more damaging than a bold implementation of reforms, given that educated youth are likely to feel even more dissatisfied as the gap between the marginalized and the protected continues to widen- a burden Sri Lanka can little afford today. v   CHAPTER 1: MACROECONOMIC BACKGROUND AND SECTORAL CHANGES IN THE ECONOMY A. MACROECONOMIC CHANGES AND PERFORMANCE 1.1 Since its transition to an open, market economy in 1977, the Government of Sri Lanka has introduced several strong structural reforms which have helped the country realize higher rates of growth. These include (i) liberalization of external trade-- Sri Lanka now has the most liberal trade regime in South Asia; (ii) development and liberalization of the financial sector- including opening of the banking sector to foreign investors, interest rate liberalization, and establishment of a stock market and inter-bank foreign exchange market, among others; (iii) privatization of many state-owned entities, the most important of which are plantations and telecommunications; and (iv) establishment of Export Processing Zones (EPZs). On the macroeconomic policy front, performance over the last decade has been mixed, marked by persistent and large budget deficits. 1.2. Sri Lanka's economic growth has averaged 5 percent annually over the last two decades, and per capita income in dollar terms doubled in one decade. Structural reforms have also transformed the economy in significant ways, namely: (i) value added in services and manufacturing has risen dramatically, and now accounts for over 70 percent of GDP; (ii) the country has become a leading exporter of garments, and has regained its place as the largest world exporter of tea; (iii) economic resilience has improved with the emergence of a dynamnic private sector; and (iv) poverty levels have declined substantially, with people in the lower deciles of the income groups being relatively well protected. B. IMPACT OF ECONOMIC TRANSITION ON UNEMPLOYMENT 1.3 These structural reforms have been at the source of considerable job creation, and Sri Lanka's overall unemployment rate has declined steadily over the years (Figure 1.1). This decline is impressive given the country's rapid increase in labor force participation in the 1980s due primarily to the influx of women into the labor market (Figure 1.2). It should be recognized however that the steady decline in unemployment is also partly due to the annual flow of labor migration which has increased tenfold over the last decade. War related recruitment (mostly from rural areas) as well as expansion of government administration have also contributed to the decline (see Chapter 5). Figure 1.1: GDP Growth and Unemployment Figure 1.2: Labor Force Participation Rate, Rates, 1971-98 1971-98 30 X, 70 - 25 ~~~~~~~~~~~~~60 20 Ratemp 650