Sri Lanka - Public Manufacturing Enterprises Adjustment Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-5351-CE REPORT AND RECOMMENDATION OF THE PRESIDENT OF TEE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED PUBLIC MANUFACTURING ENTERPRISES ADJUSTMENT CREDIT OF SDR 90.7 MILLION TO TH DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA November 2, 1990 This document has a resticted distribution and may be used by recipients only In the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Annual Averages) Sri Lanka Rupees per US$1.00 1978 - Rs. 15.61 1979 - Rs. 15.57 1980 - Rs. 16.53 1981 - Rs. 19.25 1982 - Rs. 20.81 1983 - Rs. 23.53 1984 - Rs. 25.44 1985 - Rs. 27.16 1986 - Rs. 28.02 1987 - Rs. 29.44 1988 - Rs. 31.81 1989 - Rs. 36.04 PRINCIPAL ACRONYMS ADB - Asian Development Bank CEA - Central Environmental Agency CDS - Committee of Development Secretaries CTB - Ceylon Transport Board CY - Calendar Year ERC - Economic Restructuring Credit GOBU - Government Owned Business Undertaking GDP - Gross Domestic Product IDA - International Development Association IFC - International Finance Corporation IMF - International Monetary Fund JSP - Jana Saviya Program MOI - Ministry of Industries, Science and Technology MOT - Ministry of Handlooms and Textiles Industries NGOs - Non-Government Organizations NTC - National Textiles Corporation PFP - Policy Framework Paper PIMB - Public Investment Management Board PMEAC - Public Manufacturing Enterprises Adjustment Credit PMEs - Public Manufacturing Enterprises PPF - Project Preparation Facility SAF - Structural Adjustment Facility FISCAL YEAR January 1 to December 31  FOR OMCIAL USE ONLY DEKOCRATIC SOCIALIST REPUBLIC OF SRI LANKA PUBLIC MANUFACTURING ENTERPRISES ADJUSTMENT CREDIT TABLE OF CONTENTS Page No. Credit and Program Summary . . . . . . . . . . . . . . . . . . i Reform Strategy under the Proposed Credit . . . . . . . . . . 1 I. COUNTRY POLICIES AND ASSISTANCE STRATEGY . . . . . . . . . 2 A. Background . . . . . . . . . . . . . . 2 B. Recent Economic Developments . . . . . . . . . . . . . . 2 C. The Policy Framework 1990-1993 . . . . . . . . . . . . . 6 D. Sectoral Policies and Programs . . . . . . . . . . . . . 10 . IDA's Assistance to Sri Lanka . . . . . . . . . . 13 F. External Financing Requirements . . . . . . . . . . . . 17 G. Summary Assessment . . . . . . . . . . . . . . . . . . . 18 THE PUBLIC MA_NUFACTURING ENTERPRISES: ADJUSTMENT ISSUES . 19 A. Performance of Public Manufacturing Enterprises . . . 19 B. PME Structural Issues . . . . . . . . 4 . . . . . 20 C. Institutional Issues . . . . . . . . . . . . . . . . . 22 III. PAST PME REFORM ATTEMPTS AND DIALOGUE WITH THE BANK . . . . 23 A. Past Policy and Enterprise Reforms . . . . . . . . . . 23 B. Redirection of PME Reform under the 1988-89 Policy Framework ................... . . . 24 C. Preparation of a Comprehensive PME Reform Program . 25 IV. THE PROPOSED PUBLIC MANUFACTURING ENTERPRISES ADJUSTMENT CREDIT . . . . . . . . . . . . . . . . . . . . . 27 D A. Regulatory, Incentives and Trade Reform . . . . . . 29 B. Institutional Reforms . . . . . . . . . . . . . . . . 31 C. Enterprise Reforms . . . . . . . . . . . . . . . . . . 32 D. Projected Benefits and Risks . . . . . . . . . . . . . 36 E. Credit Arrangements . . . . . . . . . . . . . . . . . 37 V. RECOMMENDATION . . . . . . . . . . . . . . . . . . . . . . 40 This document has a festricted dilstribution and may be used by recipients only in fth perotmance of their offcial duties. Its contents mnay not otherwise be disclosed without World Bank authorization.  ANNEXES ANNEX I Table 1s Key Indicators, 1986-93 . . . . . . . . . . . 41 Table Z: Balance of Payments . . . . . . . . . . . . 42 ANNEX TI Table 3: Status of Bank Group Operations in Sri Lanka 43 Table 4: External Financing Requirements, 1990-91 . . . 45 ANNEX III Table S: Value of Industrial Production, Value Added, Exports and Employment by Sub-sectors and Major PMEs, 1977-1988 . . . . . . . . . . . . 46 Table 6: Growth of Industrial Output: Sub-sectors and Major PMEs, 1986-1988 . . . . . . . . . . . . 47 Table 7: Profile of Public Man-ifacturing Enterprises Selected for Restructuring . . . . . . . . . 48 Table 8: Public Sector Industries' Borrowings, 1989 . 49 ANNEX IV Letter of Sectoral Development Policies . . . . . . . 50 ANNEX V Policy Matrix .................. . . 57 ANNEX VI Conditions of Second Tranche Disbursement . . . . . . 62 Map - IBRD 20879  i. DEMOCRATIC SOCIALIST REPUBLIC OF SRI LAN=A PUBLIC MANUFACTURING ENTERPRISES ADJUSTMNT CREDIT Credit and Program Summary Borrower: Democratic Socialist Republic of Sri Lanka Amounts SDR 90.7 million (US$120 million equivalent) Terms: IDA Credit: Standard IDA Terms (40 years maturity) Description: The proposed operation would support a reform program to commercialize, modernize and privatize public manufacturing enterprises to promote efficiency and growth, particularly of non-traditional exports. The third-year Policy Framework Paper (PFP), discussed by the Committee of the Whole and the IMF Board in October 1990, provides the macroeconomic framework for adjustment lending to Sri Lanka. The comprehensive program of stabilization and structural reforms envisaged under the third-year PFP is supported by an Economic Restructuring Credit (ERC) approved by IDA's Board in May 1990 (Cr. 2128-CE) and by the proposed PMEAC. Structural reforms supported by the ERC are complemented under this Credit with measures aimed at promoting efficient use of industrial resources and reducing direct Government involvement in industry. Estimated Disbursements: Of the proposed Credit of US$120 million equivalent, US$115 million equivalent would finance the foreign exchange cost of general imports and about US$5 million equivalent would finance a technical assistance program. The portion of the credit used to finance imports would be available for disbursement in two tranches. The first tranche of US$57.5 million equivalent would be available upon credit effectiveness; the second tranche of US$57.5 million equivalent, upon fulfillment of the second tranche release conditions (Annex VI), which is expected before the end of 1991. The remaining US$5 million would be disbursed against technical assistance services to assist the Ministry of Industries and the Public Investment Management Board to commercialize and privatize enterprises under the Ministry of Industries. Appraisal Reports Not applicatle IBRD 20879  REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED ADJUSTMENT CREDIT OF SDR 90.7 MILLION (US$120 MILLION EQUIVALENT) TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA 1. I submit the following report and recommendation on a proposed Public Manufacturing Enterprises Adjustment Credit (PMEAC) to the Democratic Socialist Republic of Sri Lanka for SDR 90.7 million (US$120 million equivalent) on standard IDA terms. 2. The proposed operation would support a reform program to commercialize, modernize and privatize public manufacturing enterprises (PMEs) to promote efficiency and growth, particularly of non-traditional exports. The third-year Policy Framework Paper (PFP), discussed by the IDA Committee of the Whole and by the IMF Board in October 1990 provides the macroeconomic framework for adjustment lending to Sri Lanka. The comprehensive program of stabilization and structural reforms envisaged under the third-year rFP is supported by an Economic Restructuring Credit (ERC) approved by IDA's Board in May 1990 (Cr. 2128-CE). In addition to addressing the country's serious internal and external imbalances, ERC focuses on (i) the public sector's size, its claims on resources and the efficiency with which it uses such resources; (ii) private sector development through improvements in the existing regulatory framework and incentive system and transfer to the private sector of activities and assets now being managed by the public sector, particularly in transport and plantations; and (iii) improving the consumption levels of the poorest segments of society. The proposed PMEAC is intended to complement structural reforms supported by the ERC with measures aimed at promoting efficient use of industrial resources and redurtng Government involvement in industry. Financing provided by the proposed PMEAC as well as the ERC should assist the Government in coping with the resource demands arising from the adjustment process which have been significantly aggravated by the Gulf crisis. 3. Reform Strategy under the Proposed Adjustment Credit. Since 1977, when the Government adopted a bold economic liberalization program after a long period of interventionist policies, it has increasingly focused on promoting private investment. Successive phases of reforms, which have been supported by six IDA-financed industrial credit operations, have liberalized investment and trade, promoted private industries and exports, and developed financial services and infrastructure support. These measures, which are indicative of the GoverNment's willingness to reduce direct intervention in the functioning of markets, have partially off-set the industrial incentive system's earlier, inward-looking bias and resulted in new activities and export earnings. But they did little to reduce the size of the public indus- trial sector created during the years of Government intervention or to modify the regulatory and incentive framework under which PMEs have been functioning. This framework has enabled the Government to sustain PMEs whose operations would not be viable in a market-oriented environment. It provided no incentives for viable PMEs to improve their efficiency, particularly by exporting, and resulted in a dual industrial structure. Private investment tended to concentrate on export-oriented, labor intensive, high growth activities, while PMEs are typically engaged in import substitution, capital  -2- intensive, slow growth activities. However, a number of PMEs, particularly in textiles, mining and minerals, have potential for higher growth, especially through export development, which has not been realized under public management. The proposed PMEAC is intended to develop this potential for export-led growth by commercializing and privatizing all viable PME activities under the Textiles and Industries Ministries through domestic and foreign joint ventures and sales of shares and by progressively phasing out non-viable activities. I. COUNTRY POLICIES AND BANK GROUP ASSISTANCE STRATEGY 4. This Chapter takes into account the third-year PFP (1990-1993) approved by the Committee of the Whole on October 16, 1990, and the Country Economic Memorandum entitled: 'Sri Lanka: Sustaining the Adjustment Process', dated September 26, 1990 (Report No. 8951-CE). A. Background 5. Following nearly three decades of poor growth performance after Independence in 1948, in 1977 Sri Lanka initiated a radical economic liberalization program. The country's initially unsatisfactory growth performance resulted from a development strategy which relied on inward- looking industrialization and increasing Goverrment intervention in the economy. These policies resulted in stagnation, unemployment rates as high as 24Z during the 1970s, recurrent balance of payments crises and foreign exchange shortages. Poor economic performance was the main reason for a dramatic reorientation in policies in 1977, when the trade regime was liberalized and Government intervention in the functioning of markets substantially reduced. The economy responded well, generating new sources of economic activity and export earnings. Gross Domestic Product (GDP) grew 5-7Z per year during 1978-85, and unemployment declined to 12? in the early 19808. 6. Sir.ce the mid-1980s, however, slow growth, macro-economic imbalances and high unemployment have re-emerged as serious problems (see Annex I). There are three reasons for this deterioration of economic performance: (i) the expansionary macro-economic policies pursued since 1977 led to unsustainably large deficits in the external and internal accounts; (ii) while the Government extensively liberalized trade, financial markets and prices, it did not reduce the public sector's size or address the root causes for its inefficiency; and (iii) the outbreak of the ethnic conflict in 1983, in the North and East, compounded by the resurgence of terrorism in the South after the Peace Accord was signed with India in July 1987, put heavy pressures on the budget, caused losses in output, and reduced foreign investment and tourism. B. Recent Economic Developments 7. Macro-economic problems after 1977 stemmed from several inter-related factors: (i) the relatively large size of the public sector, which employs over 20S of the country's labor force (i.e. 1.25 million people out of a labor  -3- force of about 6 million); (ii) ambitious public investment programs, partially financed by commercial borrowing; (iii) the country's access to international capital markets after 1977 and its borrowing on commercial terms until 1984; and (iv) the Government's reluctance to adjust the exchange rate adequately which had negative effects on export growth and balance of payments performance. These factors led to large internal and external deficits in the late 1970s and 1980s and a build-up in external debt. 8. Despite the 1977 liberalization, the Government's role in the economy increased. The availability of external finance both from donors and commercial sources led the Government to expand its investment program. Current expenditures increased both as a result of increased public sector employment and of public enterprises' need for budgetary support after they were exposed to market forces and international competition without being given autonomy to make decisions on pricing, procurement and recruitment. As total Government expenditures soared, so did fiscal deficits despite Sri Lanka's relatively high revenue to GDP ratio, which gradually increased from a historical 16-17? of GDP to slightly over 202 of GDP in the mid-1980s. The fiscal deficit during 1978-87 averaged 14X of GDP, about half of which was financed by grants and concessional loans and the other half by domestic borrowing. At close to one-half of national savings, this level of domestic borrowing has been the main cause for relatively high real interest rates. Commercial lending rates averaged 82 per year in real terms during the last four years. 9. The Government-led expansion in aggregate demand was the principal factor underlying the acceleration in inflation in the first half of the 1980's. Because of an insufficiently flexible exchange rate, inflation led to a gradual appreciation of the real exchange rate. This appreciation impeded a more vigorous development and diversification of the export sector and contributed to a current account deficit which averaged 16? of GDP in 1980-82, with a gradual decline to around 102 of GDP thereafter. As part of this deficit was financed through commercial borrowing until 1984, debt service ratios increased from 14? of exports of goods and services in 1978 to 29Z in 1988. Commercial debt reached one-third of the country's medium and long-term debt by the mid-1980s, although by the end of 1988 it had declined to 20?, i.e. US$850 million out of US$4.5 billion. Thus, the good growth performance after liberalization can be explained by a one-time efficiency gain following elimination of many of the market distortions prevailing before 1977, complemented by an expansionary fiscal policy. However, this growth performance could not be sustained largely because of the concentration and inefficient use of a significant share of the country's economic resources in the public sector, particularly in PMEs as discussed in the following Chapters. 10. The Economic Impact of Civil Disturbances. Since the early 1980s, civil disturbances intruded as a major impediment to Sri Lanka's economic development. They began as an ethnic conflict in the Northern and Eastern districts in 1983 and escalated gradually until the conflict reached major proportions in early 1987. The ethnic conflict subsided for a few months following the India-Sri Lanka Peace Accord of July 1987. By 1988, however, it had again reached serious proportions, and the Reconstruction Program for the  -4- Northern and Eastern provinces, for which IDA held a Special Aid Group Meeting in December 1987 and mobilized substantial support (US$500 million), could not be implemented at the pace envisaged originally. At the same time, nationalistic groups opposed to the terms of the 1987 Peace Accord mounted a well articulated anti-Government campaign, which escalated to the point of virtually paralyzing the country in mid-1989. 11. Consequently, defense expenditures rose from about 1Z of GDP in the first half of the 19809 to 4-5Z of GDP in 1987-89. Civil disturbances have not only put heavy pressures on the budget but also have been an important reason for the decline in the GDP growth rate to about 2-2.5Z in the last three years. Paddy production in the Northern and Eastern provinces declined by about one-third, fishing by half, and tourism inflows to the island were reduced by two-thirds. The economy's ability to weather a high level of disturbances and responsiveness to improved incentives have been remarkable, however. Tea production in 1988, for example, was at its highest level since 1965; private sector manufacturing continued to grow at over 10? through the 1988 and 1989 turbulence; and non-traditional exports continued to expand rapidly. 12. The Government should have addressed more forcefully the economic problems which emerged in the iid-1980s, but a number of factors enabled it to postpone tough policy decisions. First, the Government was able to tap concessional as well as commercial sources of financing to offset budgetary deficits, which averaged 142 of GDP between 1978-87. Second, the boom in tea prices and the inflow of workers' remittances eased the pressure on the Government. By 1986, however, it was clear that Sri Lanka could no longer sustain its high levels of fiscal and external current account deficits in the face of dwindling reserves. In November 1986 the Government articulated a three-year stabilization program which, in turn, led to the first-year PFP (1988-1990). The program's main objectives were to restore growth, reduce the fiscal deficit to an acceptable level by 1990, and stimulate export-led manufacturing output through trade reform and exchange rate depreciation. While adoption of this first-year PFP was seen as a major breakthrough at that time, its implementation turned out to be a disappointment. The sudden escalation of civil violence in the South disrupted economic activity, while relaxed public sector wage and credit policies in the pre-election period aggravated demand pressures. 13. The new Government formed in early 1989 found itself on the verge of a balance of payments crisis, accelerating inflation, and a large and widening fiscal deficit. With IDA and the IMF support it formulated a new 1-lt-92 program, reflected in the second-year PFP reviewed by the IDA Committee of the Whole and approved by the Fund Board in October 1989. The second-year PFP program focussed on the need to restore economic stability in the short-term, and to resume the structural adjustment effort initiated under the first-year PFP. The new program aimed to increase growth to 3-4Z by 1990-92, reduce inflation to 72 by 1992, reduce the fiscal deficit to 82 of GDP by 1992, and curb the external current account deficit to 62 of GDP by 1992. While these objectives may appear modest, they represented a major improvement over the country's recent macro-economic performance. On the structural reform front, the second-year PFP revived the agenda contained in the first-year PFP which  -5- was to reduce the size of the public sector and to increase the efficiency and role of the private sector, including commercialization and selective privatization of public enterprises. The second-year PFP also renewed the emphasis on poverty alleviation and the restructuring and possible privatization of the state-owned tea and rubber estates and the public bus company. During the past few months, many of the reforms identified under the second-year PFP have been translated into specific action programs under the ERC (approved by the IDA Board in May 1990). Their macroeconomic impact is described below. 14. Since the introduction of the second-year PFP program in mid-1989, overall economic management and performance has strengthened. The improvement in the security situation during the first half of 1990, especially in the South, coupled with sound macro-economic policies and good weather, contributed to an increase in the growth rate from 2.3% in 1989 to an estimated 4.8? in 1990. Given the existing relatively high revenue effort at 20? of GDP, the Government has emphasized reduction in expenditures in its effort to reduce the fiscal gap. This was also consistent with the Government's objective gradually to reduce the level of total public expenditure relative to GDP. For example, it has curtailed the Jana Saviya Program (JSP), a poorly-targeted and potentially expensive national poverty program, eliminated subsidies on wheat, rice, and fertilizers, and implemented substantial across-the-board reductions in non-wage, non-interest expenditures. Such policy actions and tightened expenditure controls kept the overall deficit in 1989 at 11? of GDP, well within the PFP target of 12.5? of GDP. To complement these measures, the Government also devalued the rupee, from Rs 35/US$ in July 1989 to Rs 40/US$ in September 1989, and tightened monetary and credit policies. Although foreign aid inflows were slightly lower than anticipated, the 1989 domestic financing of the budget at 5.1? of GDP was still lower than the PFP target of 6.3Z; this was also significantly less than the 1988 domestic financing which reached 9.4? of GDP. 15. In part reflecting these stabilization and credit policies, the exterr