Sri Lanka - Private sector assessment

Report No. 12514-CE Sri Lanka Private Sector Assessment March 13, 1995 Private Sector Development and Finance Country Department I South Asia Region Corporate Pianning Department adri Asia Regional Department, International Finance Corporation Document of the World Bank  CURRENCY EQUIVALENTS (as of March 2, 1995) Sri Lanka Rupees (Rs) US$1.00 = Rs. 50.17 Rs 1.00 = US$0.0199 FISCAL YEAR January 1 - December 31  PREFA CE 1. With a view that an efficient, expanding private sector is an essential means to promote growth and reduce poverty, The World Bank Group supports member countries' efforts to promote private sector development.' This Private Sector Assessment (PSA) of Sri Lanka provides a profile of the private sector, identifies obstacles to private sector development, and makes recommendations regarding policy reform and Bank Group strategy to support the Government's reform agenda. This study is a joint product of The Bank Group and IFC. The Sri Lanka PSA synthesizes data and analysis from field work, past and ongoing Bank Economic and Sector Work, and studies done by the IFC and the Government of Sri Lanka (GOSL). 2. To gain a deeper understanding of how businesses perceive the environment in which they operate and assess reform priorities, a Bank Group mission for the PSA visited Sri Lanka in the summer of 1993. Much of the mission was devoted to conducting interviews with private companies in the manufacturing, service and agriculture sectors operating in several geographical areas. The mission also gathered information from several Ministries, Research Institutes, Financial Institutions, Chambers, Unions, and individuals. 3. The report was substantially completed and infornally reviewed with representatives of the private sector in June 1994. However, due to political constraints, formal discussion with the Government was only held in December 1994. We would like to acknowledge, with gratitude, the time and consideration given by both Government officials and the private sector. The World Bank Group PSD strategy is fully discussed in "Private Sector Development: Strengthening the Bank Group Effort," April 26, 1991; and the June 10, 1991 supplemental paper.  ABBREVIATIONS AND PRINCIPAL ACRONYMS BAs Bankers' Acceptances BOI Board of Investments BOO Build, Operate and Own BOT Build, Operate and Transfer BTT Business Turnover Tax CDIC Capital Development and Investment Company CEA Central Environmental Authority CEB Ceylon Electricity Board CISIR Ceylon Institute of Scientific and Industrial Research CPC Ceylon Petroleum Corporation CSE Colombo Stock Exchange CWE Cooperative Wholesale Establishment DAS Department of Agrarian Services DFI Development Finance Institute EDB Export Development Board EIA Environmental Impact Assessment EPL Environmental Protection License EPZ Export Processing Zones ERC Economic Restructuring Credit ERP Effective Rate of Protection ESAF Enhanced Structural Adjustment Facility ESW Economic and Sector Work FDI Foreign Direct Investment FIAS Foreign Investment Advisory Services FO Farmer Organization FTC Fair Trading Commission GCEC Greater Colombo Economic Commission GDP Gross Domestic Product GOSL Government of Sri Lanka ICASL Institute of Chartered Accountants of Sri Lanka ID Irrigation Department IDA International Development Association IDP-III Third Industrial Development Project IFC International Finance Corporation IMD Irrigation Management Division IMF International Monetary Fund MEPA Ministry of Environment and Parliamentary Affairs  ABBREVIATIONS AND PRINCIPAL ACRONYMS (CONTINUED) NEAP National Environmental Action Plan NIC Newly Industrialized Country NRP Nominal Rate of Protection NTB Non-tariff Barrier O&M Operations and Maintenance OECF Overseas Economic Cooperation Fund of Japan PER Public Expenditure Review PFP Policy Framework Paper PFDP Private Finance Development Project PMEAC Public Manufacturing Enterprise Adjustment Credit PSA Private Sector Assessment R & D Research and Development RCDC Road Construction and Development Company RDA Road Development Authority SCB State-owned Commercial Banks SIDI Secretariat for Infrastructure Development and Investment SLR Sri Lanka Railways SLSI Sri Lanka Standards Institution SLT Sri Lanka Telecommunications SLTA Sri Lanka Telecommunications Authority SMI-IV Fourth Small and Medium Industry Project SOE State-owned Enterprises TWA Termination of Employment of Workmen Act VAT Value Added Tax  SRI LANKA PRIVATE SECTOR ASSESSMENT Contents Page No. EXECUTIVE SUMMARY . ............................................. i-xi SECTION 1: THE PRIVATE SECTOR PROFILE LA OVERVIEW .................................................... I L.B PRIVATE SECTOR DEVELOPMENT: PAST, PRESENT AND FUTURE ...... 3 I.C THE PROFILE OF PRIVATE INVESTMENT ......................... 7 a. Overview . ................................................. 7 b. Profile of the Investors ......................................... 9 1.D PRODUCT AND FACTOR MARKETS ............ .. ................ 12 a. Industry . ................................................. 12 b. Agriculture . ................................................ 14 c. Exports . ................................................. 16 d. Services . ................................................. 19 e. Factor Markets ............................................. 19 SECTION 2: POLICY CONSTRAINTS TO PRIVATE SECTOR DEVELOPMENT AND RECOMMENDED REFORMS 2.A CONSTRAINTS EDENTIFIED BY PRIVATE FIRMS . . 23 2.B MACROECONOMIC POLICY ISSUES .. 25 a. Strengthening Fiscal and Monetary Policies .......................... 26 b. Currency Exchange Policies .................................... 27 This report is based on the findings of a PSA mission which visited Sri Lanka in July 1993. Mission members included Theresa Bradley (AFTPS), Rakesh Nangia (SAIPF); Noon Mok Chung (ASTTP); Martin Rama (PRD); Mark Schacter (A FSCO); Eric Haythorne (LEGPS) and Gary Bond (CPLDI), with contributions from the Resident Mission; the Country Team and the peer reviewers, Mr. Sarath Rajapatirana (LATAD), Mr. Andrew Stone (PSD), and Mr. Vikram Nehru (EA2CO). The task received guidance from Mr. K. K. Framji (Chief, former ITF Unit) and was managed by Theresa Bradley for the Bank, and Gary Bond for IFC. Mr. Rakesh Nangia took over task management in December 1994 and finalized the reportfollowing discussions with the government and the private sector. Messrs. Paul Isenman and Frederick Kilby are the Department Director and Division Chief respectively. Secretarial support was provided by Umes. Lai-Foong Goh and Joan Mongal.  Page No. 2.C PRIVATIZATION AND RESTRUCTURING STATE-OWNED ENTERPRISES.. 27 a. Privatization . ................................................ 27 b. Restructuring . ................................................ 29 2.D INCENTIVES POLICIES .................. ....................... 29 a. Overview ................................................... 29 b. Trade Policies . ................................................ 29 c. Corporate Tax Policies ........... ............................... 32 d. Implementation Issues: Interface of Government and Private Firmns .... ...... 35 2.E THE FINANCIAL SECTOR .35 a. The Banking Sector .37 b. Capital Markets .38 An Overview .38 Reform Measures .39 2.F INFRASTRUCTURE SERVICES .42 a. Overview .42 b. Transportation .43 Roads .43 Railways .44 Ports .44 The Transportation System .45 c. Telecommunications .45 d. Energy .47 Electricity .47 Petroleum .48 e. Irrigation .48 2.G THE LEGISLATION AND REGULATION OF COMMERCIAL ACTIVITIES . . 50 a. Overview .50 b. Entry Barriers .51 c. Factor Markets .52 Labor .52 Land .54 The Plantations Sector .55 d. Exit Barriers ....... .......................................... 56 e. Regulations Requiring Stricter Enforcement .56 Competition Policy .56 Environmental Protection Policies .57 Safety Standards .58 f. The Judicial System. ............ 59  Page No. 2.H SUPPORT SERVICES FOR THE PRIVATE SECTOR AND HUMAN RESOURCE DEVELOPMENT ........ ............... 60 a. Support Services . ...................................... 60 Investment Promotion .................................... 61 Industrial Standards ..................................... 62 Technology Research and Marketing Services ........ ............... 62 Information Dissemination .................................... 64 b. Human Resource Development .................................... 64 Entrepreneurs .............. ...................... 64 Civil Service ........................................ 65 Workers .............. ......................... 65 SECTION 3: STRATEGY FOR PRIVATE SECTOR DEVELOPMENT 3.A OVERVIEW . .................................................. 67 3.B WORLD BANK GROUP STRATEGY .67 The World Bank .67 a. Increase Competition in Private Sector Markets .68 b. Mobilize Private Investment Funds .69 c. Improve Efficiency of Factor Markets .70 d. Reduce the Public Sectors' Role in Commercial Activities .71 e. Improve Infrastructure Services .71 f. Improve Support Services and Invest in Human Capital .72 IFC .73 FIAS Strategy ..74 ANNEX-STATISTICAL TABLES Table I - Table 11 ............ 78-90  Page No. LIST OF TABLES Table 1.1: Income, Investment and Savings--Cross Country Comparison (1992) .......... 2 Table 1.2: Cost of Industrial Production, 1993 ................................ 14 Table 1.3: Tea Productivity--International Comparison .......................... 16 Table 1.4: Trends in Exports (current US$) .................................. 18 Table 1.5: Labor Cost Comparison ........................................ 20 Table 1.6: Wage Rigidity and Inflationary Inertia (Based on Quarterly Data) .... ...... 21 Table 1.7: Indexation to Government Wages ................................. 21 Table 2.1: Estimates of Industrial Trade Protection in Sri Lanka (1990) ............... 30 Table 2.2: Investment Capital Flows (Rs. Million) .............................. 38 LIST OF FIGURES Figure 1.1: Real Investment Trends, (1992 Rs. Millions) .......................... 2 Figure 1.2: Private Sector Share of Value Added By Economic Activity (Percent) .... .... 3 Figure 1.3: Capacity Utilization Rates, 1992 ................................... 6 Figure 1.4: Shares of Commercial Banks' Advances by Maturity (1992) ............... 8 Figure 1.5: Shares of Commercial Banks' Advances by Economic Activity (1992) .... .... 8 Figure 1.6: Industrial Output Indices (1982 Constant Prices) ...................... 13 Figure 1.7: Composition of Exports (Percent of Total Value) ...................... 16 Figure 1.8: Export Diversification Indices ................................... 17 Figure 2.1: Constraint Rankings: Sri Lanka PSA Survey ......................... 24 Figure 2.2: Prime Interest Rates ........................................... 25 Figure 2.3: Financial Sector Deepening (Ratio of M2 to GDP) ..................... 36 Figure 2.4: Interest Rate Spreads .......................................... 36 LIST OF BOXES Box 1.1: Government Intervention in Private Markets ........................... 3 Box 1.2: Recent Macroeconomic Trends, 1990-1993 ............................ 5 Box 2.1: Firms' Views on Tax Incentives ... ................................ 34 Box 2.2: Experiences in Privatization of Electricity Utilities ....................... 48 Box 2.3: TWA Reform: Lessons Learned .......... .......................... 54 Box 2.4: Evidence of Industrial Safety Problems in Sri Lanka ..................... 59 Box 2.5: World Bank Experiences in the Use of Cost Sharing Grants ................ 63  EXECUTIVE SUMMARY I. OVERVIEW OF THE POLITICAL AND ECONOMIC FRAMEWORK FOR PRIVATE SECTOR DEVELOPMENT 1. In 1977, the Government of Sri Lanka (GOSL) embarked on a new strategy for economic development, the thrust of which was to transfer the leading role of the economy to the private sector and foster export-led growth. Sri Lanka has made significant progress, particularly in the areas of tariff reform, liberalizing the foreign exchange market, privatization of state enterprises engaged in productive activities, and streamlining investment approval procedures. These efforts have led to a progressive improvement in the environment for private sector investment and growth. 2. Overall, private investors have been bullish in their response to market oriented reforms, although their response was hesitant during periods of macroeconomic instability and escalation of the ongoing civil war. After the initiation of reforns in 1977, real aggregate investnent activity in Sri Lanka increased rapidly and the private sector's contribution to this surge was significant. Private investment averaged 13% growth per annum in the first four years after reforms began. Net foreign direct investment rose from a negligible level in 1978 to average over 4% of Gross Domestic Investment during 1979-1982. These actions fostered a period of rapid growth, with an average 1978-1982 Gross Domestic Product (GDP) growth rate of 6%, led by an accelerated 13% p.a. growth of exports. Although the private sector maintained its share of aggregate investment during the 1983-1988 period of civil war and macroeconomic instability, investor confidence waned and the acceleration of investment halted. New impetus to reforn came in 1989, as the intensity of the civil war subsided. Since then, encouraging progress has been made in the areas of macroeconomic management, privatization of manufacturing enterprises, tax reform, trade reform, and streamlining investment approval procedures. As the reform process accelerated, private investment activity gained further strength, increasing from 11% of GDP in 1988 to almost 18% by 1993. Total private sector contribution to investment increased from 50% in 1989, to 68% by 1993. Foreign investors, in particular, responded positively to these market-oriented reforns, and FDI rose from negligible levels in the late 1980s to 7.3% of total investment in 1993. Spurred by both foreign and domestic private investment, economic growth averaged 5% between 1990-1992, and 5.7% in 1993. 3. Recent private sector performance has been particularly strong in the manufacturing export sector, which has been the target of government reforms designed to promote an enabling business environment. Manufacturing value added expanded at an average pace of 7% p.a. in 1990- 92. By contrast, agriculture's performance stagnated (about 2% p.a. growth over the past ten years-- half the national average), particularly in the tree crop sector, mainly due to inefficient management of the public plantations and inappropriate trade and factor market policies, as well as poor weather conditions. Although recent growth in the services sector, sparked by the recovery in tourism, is encouraging, inefficiencies in the large public service entities stifle some of its potential growth. 4. Notwithstanding Sri Lanka's past commendable progress, many obstacles to private sector development remain. In this regard, the adverse effect of the civil war on the private investment climate in Sri Lanka is of critical importance. The civil war disrupts private sector economic activity in the conflict areas, deters private and foreign long-term investment, and  - ii - contributes to the Government's hesitancy in policy making and implementation. Moreover, the direct financial cost of the war (defense expenditures comprise about 4% of GDP) contributes to the fiscal deficit, drawing resources from the private sector. Successful resolution of the civil conflict is critical to realize the full potential of Sri Lanka's private sector. 5. Businesses operate in Sri Lanka amidst unpredictable and non-transparent government policy making. Some progress in this area has been made through streamlining the investment approval system. However, the policy making environment has recently become murkier, with government official relying on discretionary judgement with different decisions made for similar cases rather than applying steadfast neutral rules to each case. 6. Sound macroeconomic policy is also an essential element to sustaining and increasing private sector development. Top among the concerns of businesses in Sri Lanka is the prevailing high cost of finance. High interest rates are partly the result of shifting domestic funds toward financing GOSL's high fiscal deficit, rather than providing funds for private investment. The recent gradual reduction in the fiscal deficit to slightly over 8% of GDP in 1993 and privatization of 36 public enterprises has helped reduce the crowding out problem, but the mixture of fiscal and monetary policies continue to put upward pressure on interest rates. Continued reduction of the deficit would foster further growth in private investment. GOSL's macroeconomic policy agenda, set forth in recent Policy Framework Papers and supported by the International Monetary Fund's (IMF's) third-year Enhanced Structural Adjustment Facility seeks to achieve a stable macroeconomic environment conducive to sustained private sector investment and growth. iI. THE INVESTMENT CLIMATE: VIEWS FROM PRIVATE FIRMS 7. To gather evidence of how the business environment appears from the important, albeit subjective perspective of the private enterprise, the Private Sector Assessment (PSA) conducted a survey of 48 firms in the manufacturing and service sectors in Sri Lanka. Overall, the business community strongly supports the recent thrust of reforms, in particular GOSL's efforts to deregulate economic activity and privatize public enterprises engaged in productive activities. Except for labor regulations and Customs' procedures, many firms note that the degree of bureaucracy inherent in business-government interaction in Sri Lanka has declined. Firms specifically mention improvements in streamlining investment license procedures as a strong positive development. 8. There are, however, several important issues that require further effort to improve the enabling environment for private sector development. The survey's findings indicate that on average firms believe that two macroeconomic issues, high interest rates and the level of taxation, are the strongest obstacles to expanding and diversifying their businesses. Following these macroeconomic issues, firms indicate that the medium-term investment climate is marred by burdensome regulations on terminating workers and unpredictable, inconsistent and non-transparent mechanisms to implement government policies and regulations. Firms also report being strongly impaired by infrastructure limitations, with roads, telecommunications and electric power among the leading constraints. In the area of human capital, limited access to qualified managers emerges as a relatively important problem. High import duties and price uncertainty also appear among the leading constraints.  - iii - III. THE REFORM AGENDA 9. Lessons from East Asia's Newly Industrialized Countries (NICs) indicate that sustained private investment and growth results from the positive interaction of four critical aspects of economic policy: macroeconcomic stability, openness to international trade, human capital formation, and an environment that encourages private investment and competition. For all of these countries, no single policy has ensured economic growth; strong and effective policies in all four critical areas over a sustained period have been key. Moreover, economic policies in these countries were flexible and pragmatic in selecting policy instruments in pursuit of the objectives of macroeconomic stability and export growth; governments were willing to try new approaches, discard unsuccessful ones, and keep those instruments that worked. 10. Sri Lanka has made major strides in reform within all four of these economic policy areas, and the private sector response has been significant. Nonetheless, for Sri Lanka to achieve its economic objectives, GOSL must continue with policy changes and carry through its reform agenda. An across the board effort is needed to make the provision of public services and implementation of regulations and laws simpler, transparent and consistent. GOSL should also abandon its hesitant approach to policy making, which in the past has created uncertainties for private investors, and pursue reforrns steadfastly. Achieving these goals will require institutional strengthening, as well as effective coordination among government agencies. The highest priority is accorded to reforms aimed at: (i) increasing competition; (ii) mobilizing long-term private investment funds; (iii) increasing efficiency of factor markets; (iv) reducing the public sector's role in commercial activities; and (iv) improving public support services and investing in human capital for private sector development. The major policy recommendations of the PSA within these four categories are summarized in the matrix attached to the Summary. These priorities for reform are based on the firmn-level survey, as well as economic and sector work conducted by GOSL, the Bank Group and other sources. i1. Since the remaining agenda for policy reform is extensive, GOSL should consider establishing a tripartite Private Sector Development Consultative Group, which includes high-ranking representatives from government, private business and labor, that would provide a channel to facilitate communication and consensus-building during the process of reform aimed at private sector development and ensure coordination among key constituencies. The Consultative Group's objective would be to help ensure that GOSL priorities for reform reflect the need to alleviate constraints to private investment that would lead to long-term employment generation and sustained economic growth. Increasing Competition 12. Trade reforn and rationalizing the tax holiday system is particularly important to enhance competition. While trade reform in Sri Lanka is advanced in relation to the other countries of South Asia, when compared to East Asian countries, it remains relatively protected and regulated in both the agriculture and manufacturing sectors. Further progress in reducing and rationalizing nominal and effective protection is needed. Continued trade reform is accorded high priority because it will reduce the anti-export bias of the current trade regime (easing the concern of businesses surveyed by the PSA that import duties are too high) and increase competition in the domestic economy. Moreover, the current comfortable reserve level facilitates trade liberalization.  - Iv - 13. Tax holidays in Sri Lanka, which are granted on a case-by-case basis, are difficult to monitor for fraud and evasion. The PSA survey indicates that many firms obtain tax holidays to subsidize investment that they would have made even without the incentive. The case for tax holiday incentives is even weaker with respect to potential investors. Although Sri Lanka's incentives are more generous than other investment sites, potential investors view location factors and labor costs as the most important factors for exploring Sri Lanka as a production site. It is important that the Government's plans to streamline the tax incentive system to promote exports, which were announced in the context of the 1994 budget, are fully implemented. Mobilizing Long-term Private Investment Funds 14. The high cost of finance is, on average, the dominant obstacle to expansion and diversification among firms surveyed for the PSA. Real prime lending rates in Sri Lanka have been relatively high, in the 8-10% range in recent years. Crowding out due to high fiscal deficits, inefficiencies in the financial system, and relatively low domestic savings (15% of GDP) contribute to the high cost of finance. 15. A series of reforms to mobilize long-term private investment funds are necessary to sustain the recent spurt of private sector investment. Initiatives are required on two fronts: (i) raise the domestic savings effort so as to increase the funds available for private investment, and (ii) banking sector reforms. Progress on the public savings effort needs to be achieved through reduced fiscal deficits, but higher private savings in the coming years can also make an important contribution. Similarly, reforms in the banking sector would encourage more efficient mobilization of investment funds. GOSL should move rapidly to privatize the two state-owned commercial banks, develop a regulatory framework for the private insurance market, and privatize the state insurance companies. Other measures to encourage mobilizing long-term capital for private investment, include: reform of the contractual savings institutions; development of market-oriented procedures for issuing debt instruments; introduction of variable interest rate lending practices by commercial banks; and extending the maturity structure of government securities. In addition to mobilizing more investment funds from the local market, Sri Lankan firms need improved access to international debt markets to finance productive projects. A gradual reduction of the corporate income tax rate is also recommended to help increase the level of retained earnings, which is a major source of investment funds. Increasinz Efficiency of Factor Markets 16. Reforms that improve efficiency in the allocation of the factors of production at the firm level are needed to reap full benefit from trade liberalization and other reform measures. The Termination of Employment of Workmen Act (TWA) should be revised, with a view to improving labor mobility, particularly in the manufacturing and service sectors. Land market reform that reduces restrictions on land use and ownership is of special importance for future development of agriculture. 17. Labor Market. The persistently high unemployment rate (currently at 13%) and the long average duration of unemployment (85% of the unemployed spend more than on year searching for a job) are important concerns. Much of this relates to the wage and employment policies in the public sector; however, it also reflects distortions in the private sector labor market caused by the TWA.  v - 18. The private labor market, which employs about three-fourths of the labor force, is segmented. The informal sector and about four-fifths of the formal private sector functions well, with regard to wage flexibility and labor mobility. This unregulated component of the private labor market is concentrated in non-plantation agriculture, small sized enterprises in the service and manufacturing sectors, and finns located in the Export Promotion Zones. Regarding the remaining one-fifth of the private labor market in the formal sector, which is concentrated in medium and large scale firms in manufacturing and services, while wages are largely market determined, flexibility in the labor market is constrained by the TWA. Less diversified firmns, with limited ability to redeploy redundant workers into other areas of their business, tend to bear a relatively high burden. Both the TWA and wage determination issues are critical elements in the ongoing process of increasing the private sector's role in the state-owned plantations subsector. 19. The TWA restricts the ability of firmns to fire redundant workers. While the firms subject to the TWA employ only about one-fifth of the private labor force, their potential contribution to the economy is significant. The TWA hampers labor mobility and turnover, and contributes to long unemployment spells, characteristic of Sri Lanka's labor market. GOSL could consider amending the TWA within the following broad framework: (i) the employer must give the employee notice of termination in writing within a reasonably predetermined time period; and (ii) an upper bound to severance pay based on the number of years of service is set. Labor disputes, including complaints that union leaders were unjustly fired could be handled adequately under the existing framework of the Industrial Disputes Act. 20. With greater labor mobility, long-run benefits from proposed trade reformns would be augmented. Revision of the TWA would also enable poorly performing firmns to restructure operations in a timely and orderly fashion, enhancing the long-term viability of these firms. In addition, the average unemployment spell would most likely decline, which would help alleviate the socially explosive problem of youth unemployment. In the long-run, there should be more job creation, as the current costs of retrenchment are likely acting as a deterrent for investment in labor-intensive projects. 21. Land Market Reforms. Private firms engaged in manufacturing and services are not unduly constrained by limited access to land. However, with more than 80% of land publicly owned, land use and ownership policies are critical to the private agricultural sector. Sri Lanka's potential for private sector development in the agricultural sector is greatly impaired by restrictions on land ownership and use. 22. In Sri Lanka, diversification away from low yielding paddy rice and toward higher value-added crops, particularly fruits and vegetables, is necessary to enhance growth in the sector. Although a combination of policies, including trade and price policies, and a lack of production and marketing skills in agriculture and agribusiness have deterred private investment in new crops, land policy is among the most important constraints. In particular, diversification into fruit and vegetables requires substantial areas of land to provide the necessary critical volume to assure buyers of continuity in supply and realize export opportunities. 23. Although GOSL recognizes that an efficient land market is important, the Government has hesitated to deal effectively with this area of the reform agenda. Implementation of the 1991 amendment to the Agrarian Services Act, which enables paddy farmers to reallocate their land to other crop production, has not been satisfactory. The Agrarian Services Commission has not redirected its activities and paddy farmers' awareness and understanding regarding the amendment is in doubt.  - vi - There is need to remove distortive incentives that affect land use, to initiate legislative action for lifting restrictions on private land ownership, and to simplify procedures relating to the transfer of state land. 24. The Plantations Sector. Regarding factor market issues, the plantations sector involves a unique public/private sector business relationship. Management of state plantations was recently transferred to private companies under 5-year management contracts. GOSL should move rapidly to change from these short term management contracts to long-tern lease on land, with a view to enhance the incentives for the private companies to make the necessary and large (and labor intensive) investment in planting the higher yield variety and respond to changes in international market developments. Under the lease arrangements, labor disputes would be settled by collective bargaining by labor and management. 25. Conversion to long-term lease arrangements with the private sector, however, will alone not solve the major economic development challenges within this area of the island. Plantation workers face serious obstacles to geographic mobility. Growth in employment of the young generation of workers, inter alia, will require diversification of the agriculture sector into higher value crops, as well as new labor-intensive investment. In turn, this will require improvement in physical infrastructure, including transportation, power and telecommunications, in addition to improvement in labor relations. Reduce the Public Sector's Role in Commercial Activities 26. With a view to improve economic efficiency, as well as reduce direct crowding out of private sector activity, GOSL should continue its privatization program, which focuses on state owned enterprises in manufacturing, as well as expand the scope of the program to include: (i) infrastructure services; (ii) the state banks and insurance companies; and (iii) the state plantations. The recent announcement by the Government to privatize Air Lanka, the insurance companies and Sri Lanka Telecoms is a welcome step. Other important privatization candidates include the state-owned commercial banks and the state plantations. Improve Infrastructure Services 27. Regarding the infrastructure sector, firms surveyed for the PSA indicate that poor infrastructure services, with particular focus on road capacity, telecommunications and power, were among the strongest obstacles to their businesses' expansion and diversification. GOSL's strategy to alleviate these infrastructure bottlenecks includes: (i) expanding the role of the private sector in provision of infrastructure services through BOO (Build, Operate and Own) and BOT (Build, Operate and Transfer) schemes; and (ii) privatizing/divesting SOEs, with a view to either increase competition or ensure prudently regulated monopolies. GOSL, however, must move quicker, particularly with regard to improving road capacity in the urban areas and reliability of electric power to private firms, to facilitate further export grovwth and product diversification. GOSL should consider options to privatize road maintenance and rehabilitation activities, power transmission and selected rail services. The pursuit of private sector participation in port services should also be accelerated over the short- term. 28. In addition to opening up avenues for private entry, appropriate policy reforms and development of public institutional capabilities are needed to strengthen remaining SOEs' abilities to  - vii - meet private sector demand for infrastructure services in a cost effective manner. For the Ceylon Electricity Board (CEB), political interference, especially in investment decisions, leads to poor financial performance and low quality services. With regard to the transport sector, the major sources of inefficiencies and high transportation costs in Sri Lanka relate to inadequate linkages between modes of transportation. Strengthening the coordination among public institutions servicing components of these linkages, such as the Colombo port-rail-road network, would help alleviate inefficiencies and high costs of transporting goods. Improve Support Services and Invest in Human Capital 29. Human Capital Development. The ability of Sri Lankan firmns to sell products on competitive and rapidly changing international markets is based ultimately on the capabilities of the entrepreneurs and employees. In conjunction with advances in the macroeconomic and sectoral reform agenda targeted toward an open, private sector-led economy, GOSL can also play a role in furthering human capital development within the private sector by: (i) building capacity of public institutions to supply, with private sector participation, demand-driven support services in the areas of export promotion, marketing assistance, and trade and technology information; and (ii) implementing policies regarding education and vocational training that closely match investment in human capital to skills demanded in the private sector. 30. Firrns complain extensively about the poor quality of existing vocational training programs and political patronage. An in-depth review of training programs, many of which are expensive, is needed. GOSL should switch from supply-driven to demand-driven training. There is also evidence that investment in human capital by the private sector is needed to improve the capacity of its managers and entrepreneurs. 31. Support Services. The PSA survey of private firms in Sri Lanka indicate that the efficiency df several public institutions promoting private sector development in Sri Lanka is also questionable. Policy reformn in this area is progressing, albeit slowly. Efforts are underway by GOSL to transform the Board of Investments into an effective promoter and facilitator of both foreign and domestic investment. In addition, public institutions with mandates to service private business, such as technology development institutions and research institutes, need revision with a view toward encouraging more demand-driven activities by: (i) transforming these public institutions into quasi- public or fully private -institutions to ensure that the private sector has vested interest in its functioning; and (ii) attracting and retaining revenue from private sector clients. IV. WORLD BANK GROUP STRATEGY 32. GOSL has set an ambitious goal of eradicating poverty and achieving NIC status for Sri Lanka by the turn of the century. To assist GOSL in achieving this goal, The World Bank Group is engaged in policy dialogue with GOSL and providing assistance in the Government's reform effort through lending operations, Economic and Sector Work, and coordination with other donor agencies. In line with GOSL's renewed focus on private sector development, IDA's lending program focuses on continued improvements in the economic and administrative environment for private sector development, a more rapid withdrawal of GOSL from commercial activities, and a strengthening of the public sector's role in areas in which it has a comparative advantage, with particular focus on maintaining the country's social achievements. IFC activity is concentrated in capital markets. During  - viii - FY1989-93, the World Bank Group approved 18 credits totaling $745.3 million in support of the Government's reform program. 33. Recent Government macroeconomic and trade policy reformns and disengagement from commercial activities have been supported by the Economic Restructuring Credit (ERC) and the Public Manufacturing Enterprises Adjustment Credit (PMEAC), both approved by the Board in 1990. Financial sector reforms are supported by the Private Financial Development Project (PFDP), which is helping establish a market for public and private debt instruments and improve the efficiency of financial intermediation for term lending to the private sector, and supporting privatization of the state insurance companies. IFC is also active in the financial sector: currently three of its five projects are in capital markets. IDA is directly supporting the expansion of the private banking sector; the state- owned banks being ineligible intermediaries under PFDP. In addition, the IDA Fourth Small and Medium Industry Project (SMI-IV) supports mobilization of investment funds for small- and medium- private enterprises through financial institutions. Efforts are also underway to improve the management and regulatory capacity of the Central Bank, and there is ongoing policy dialogue regarding the need to privatize the state-owned commercial banks. In this regard, PFDP and SMI-IV are helping GOSL prepare for privatization by supporting the SCBs' use of profitability targets and international accounting and disclosure standards. In the agriculture sector, IDA would support private, export-oriented, agri-business and strengthen support services to help accelerate sector growth and productivity, if land use restrictions were relaxed. In addition, IDA would support further reforns in plantations and streamlining the Mahaweli Authority. 34. The World Bank Group is also active in the infrastructure and energy sectors. IDA lending to the transport sector is directed at easing transport bottlenecks through rehabilitating and upgrading of the road network, institutionalizing proper road maintenance methods, and improving sectoral planning of policies and programs. Bank lending operations have also supported the Government's decision to transform the Sri Lanka Railways from a government department to an independent authority, a first step in the restructuring of the railways. In telecommunications, Bank lending has also supported the recent conversion of the Sri Lanka Telecommunications Department to a public corporation. In addition, selected telecommunications services are also being opened up to the private sector, and future privatization is part of our ongoing support. Recently, IFC approved a $2.0 million equity investment in Lanka Cellular to help finance Sri Lanka's second cellular telecommunications network. Regarding infrastructure services to the agriculture sector, IDA lending has supported the transfer of operations and management of small-scale irrigation systems to local private farner organizations. In the energy sector, IDA lending has provided financing for a number of power projects for generation, transmission and distribution and will continue to support GOSL's efforts to secure economically efficient supplies of energy. 35. IDA lending has also been directed at public institutions that provide services to the private sector and human capital development. The existing lending program in education comprises the General Education and Second Vocational Training projects. The World Bank Group is also supporting improvements in the provision of public services to the private sector. For example, to help GOSL refine its investment promotion strategy, FIAS, a joint facility of the World Bank Group, is providing advice to GOSL, with a view toward creating a level playing field for foreign and domestic investors and strengthening BOI's institutional capacity to function as a promotion and investor servicing agency. FIAS is assisting GOSL in developing a new investment policy statement, which will identify the Sri Lankan "package" for foreign direct investment and define the new role of the BOI. Subsequently, FIAS will assist GOSL in the institutional restructuring of BOI, including the  - ix - preparation of a corporate plan. In addition, the PFDP and SMI-IV IDA operations support implementation of elements of GOSL's National Environmental Action Plan (NEAP), and the IDP-III and the Agriculture Research project provide technical assistance to several public agencies providing support services to the private sector. 36. Recent Bank Economic and Sector Work (ESW) supports policy dialogue and provides the analytical underpinnings of the lending program. Our on-going dialogue with GOSL regarding macroeconomic policy reforms is reflected in recent Policy Framework Papers and Country Economic Memoranda. The 1993 Public Expenditure Review helps highlight further areas of public sector rationalization. A recently completed telecommunications study examines issues and options for privatizing the telecommunications sector. Similarly, a study of reform options to enhance the private sector's role in the tree crops sector was completed in 1993. A 1991 FIAS study identified ways to improve the effectiveness of BOI in promoting and facilitating investment. Regarding the financial sector, a 1991 study of the sector supported adjustment dialogue and helped define priorities for financial sector operations. The Bank's recent ESW has also examined factor market reforms. Selected labor market issues have been reviewed in the PSA. An ongoing Agriculture Diversification Study would help form the framework for future policy dialogue regarding land market reforms. IDA's strategy for the education sector is evolving at this time through ESW, which includes a comprehensive review of the education sector completed in FY94, that will support policy dialogue and help design potential investment operations with a strong policy content. 37. As Sri Lanka receives substantial external assistance, (over US$401 million net disbursement from the donor community in 1993), effective aid coordination is an essential component of World Bank Group strategy to assist GOSL. The 1993 Country Economic Update served as a background document for the last Sri Lanka Aid Group Meeting. In addition to the Aid Group Meetings, coordination of donor assistance in activities related to private sector development encompass frequent policy and program consultations with major donors, consultation among donor resident missions, shared responsibility for ESW, and cofinancing of operations. For example, IDA and the IMF have closely cooperated in conducting policy dialogue surrounding the annual Govemment's Policy Framework Paper and, most recently, in preparing the third-year Enhanced Structural Adjustment Facility (ESAF). The Bank Group intends to continue and strengthen this approach. 38. IDA's involvement in private sector development over the next few years is expected to be in the form of analytical support under ESW and a limited number of operations. In the short- term, the Bank will provide support for the privatization of Air Lanka, insurance companies and Sri Lanka Telecoms which have been announced. The challenge for the Bank is to help minimize reform slippages, exploit opportunities for progress and in this connection, given limited Bank Group resources, maintain focus while casting wide the dialogue net. The main sectors for the International Finance Corporation (IFC) to focus on in the immediate future will be tourism, infrastructure (power, and capital market activities. IFC will continue to explore the expansion plans of the big corporate groups of Sri Lanka (both listed and unlisted) and monitor proposals which may represent appropriate investment opportunities.  - x - PRIVATE SECTOR DEVELOPMENT POLICY MATRIX OBJECTIVE POLICY TOOLS KEY POLICY RECOMMENDA TIONS A. INCREASE 1. Neutral, transparent and consistent a. Implement the new tax policy in the new Inland Revenue COMPETITION mechanisms to implement GOSL Act ending tax holidays and providing a concessionary rate policies. of 15% for export industries. BOI to implement regulation ending the approval of tax holidays under the BOI Act provisions to override Inland Revenue Act. 2. Tax, Trade and Pricing Policies, a. Continue to consolidate and simplify the tariff structure with the objective of adopting a single band structure at 15% by 1998. b. Eliminate trade and price distortions related to diversification into high value-added agriculture. c. Introduce the VAT in a revenue neutral manner by limiting exemptions and the number of goods under concessional rates. d. Continue to rationalize BOI tariff concessions. B. MOBILIZE 1. Corporate Taxation. a. Reduce the corporate income tax. INVESTMENT FUNDS FOR THE 2. Develop Viable Bond Market. a. Develop market-oriented procedures for issuing debt PRIVATE SECTOR instruments. b. Grant contractual savings institutions complete investment autonomy, to enable investment in non-government securities. 3. Develop T-bill Market. a. Extend maturity structure of government securities. 4. Banking Sector Reforms. a. State Banking Reforms: (i) Commercialize the State Commercial Banks (SCBs) using profitability targets; (ii) Improve SCBs' project preparation and monitoring; and (iii) Privatize SCBs. b. Insurance Market Reforms: (i) Develop regulatory framework for insurance industry; and (ii) Privatize the state-owned insurance companies. c. Improve Central Bank management and regulatory capacity, including bank supervision. 5. Mobilize Domestic Savings. a. Reduce fiscal deficit. C. IMPROVE 1. Labor Market Reforms, a. Revise the Termination of Employment of Workmen Act to EFFICIENCY OF permit firms to have flexibility in employment decisions. FACTOR MARKETS 2. Reform of Land Ownership and a. Remove ceilings on ownership of private land; simplify Land Use Regulations, particularly procedures to transfer state land. in the agriculture sector.  - xi - OBJECTIVE POLICY TOOLS KEY POLICY RECOMMENDATIONS D. REDUCE PUBLIC 1. Privatize State-Owned Enterprises. a. Privatize targeted SOEs in manufacturing and service SECTOR'S ROLE IN sectors. COMMERCIAL b. Establish a fully state-owned holding company with 99 ACTIVITIES years lease of all state plantations; issue subleases for 50 years to the regional plantation companies and divest them to private sector investors. E. IMPROVE 1. Enable private sector competition in a. Mobilize private funds for infrastructure through BOO/BOT INFRASTRUCTURE the infrastructure sector. schemes. SERVICES b. Establish regulatory framework to enable private sector provision of infrastructure services. c. Privatize selective infrastructure services (e.g., basic telecommunications, power transmission, petroleum distribution, selective rail, road, and irrigation operations). 2. Improve public provision of a. Increase power generation capacity, including rehabilitation infrastructure. of power plants and distribution and transmission systems. b. Improve inter-modal transportation network, particularly road-rail-port network in Colombo, c. Improve Colombo port operations, including computerizing the Port Authority's information system to manage berthing assignments. F. IMPROVE SUPPORT 1. Restructure public institutions a. Fully implement plan to restructure the Board of Investment SERVICES AND directly supporting the private for promoting and facilitating domestic and foreign INVEST IN HUMAN sector. investment. CAPITAL b. Increase private sector participation in Research Institutes' activities and in Technology Development by: (i) transforming these public institutions into quasi-public or fully private institutions to ensure that the private sector has vested interest in its functioning; and (ii) attracting and retaining revenue from private sector clients. 2. Invest in human capital to improve a. Improve formal education to establish stronger links to labor productivity in industry and employment opportunities in the private sector. finance sectors. b. Increase participation of private employers in the management of public vocational training programs.  SECTION 1: THE PRIVATE SECTOR PROFILE L.A OVERVIEW 1.1 Sri Lanka is a 66 thousand sq. km. island of 17.4 million people. Although per capita income is higher than other South Asian countries, Sri Lanka is considered a low income country by World Bank standards (see Table 1.1). The 9.7 billion US$ economy draws strength from a richly varied natural resource base, a moderately expanding population covered by extensive social services and an adult literacy rate of almost 90%. Sri Lanka's external competitiveness reflects its inexpensive labor, rich agricultural land and potential tourist sites. Economic growth averaged above 5% per annum over the last four years. Nonetheless, Sri Lanka suffers from an on-going ten year civil war, which has prevented the full use of the country's resources and discouraged foreign direct investment and tourism. Table 1.1: Income, Investment and Saving-Cross Country Comparison (1992) Income GDP Growth Rate Private Sector FDI Share Domestic Saving per capita 1980-1990 Share of Investment of Investment Share of GDP (1991) Bangladesh 220 4.3 54 0.2 6.2 India 330 5.3 60 n.a. 21.6 Pakistan 400 6.3 55 3.1 14.0 Sri Lanka 500 4.0 63 3.0 15.1 Indonesia 610 5.5 55 3.6 37.3 Thailand 1570 7.6 82 5.1 35.0 Malaysia 2520 5.2 67 24.2 41.9 Source: World Tables and IMF IFS, 1992. 1.2 Sri Lanka's private sector is the principal source of investment and growth, accounting for 78% of GDP' and 63% of aggregate investment in 1992. Comparative data for other Asian economies show that the role of private investment is higher than other South Asian economies, but below better performing economies, such as those of Malaysia and Thailand. The share of investment from foreign business is small, as is the case for other South Asian countries. This calculation includes value added from state plantations that do not belong to the two major state plantation corporations, which combine represent (in terms of acreage) about 75% of the state plantations. Even if this discrepancy was eliminated, however, the measurement of the private sectors contribution is likely to be underestimated, to the extent that the calculation excludes value added from the private informal sector. Estimates suggest that informal activities contribute about 50% of value-added (Nimal Sanderatne. "The Infornal Sector in Sri Lanka: Dynamism and Resilience." In The Silent Revolution, E. Chickering and M. Salahdine, ICS Press, San Francisco, 1991).  1.3. Private investors have been bullish in their response to market oriented reforms initiated in 1977 and in 1989, and hesitant under conditions of civil war and macroeconomic instability during 1983-1989 (see Figure 1.1). Private sector investment has been particularly strong in sectors in which reforms were designed to create a market-friendly business environment. Figure 1.1: Real Investment Trends (1992 Rs. Millions) 110 s: 50_/ 30 0 20 j 1980 1'92 1194 I 19 9 I 1988 I 1990 1992 1979 1991 1983 1985 1907 1989 1991 o3 TOTAL 0POI-ATE Source: Central Bank Note: Private investment data excludes investment by state-owned enterprises. Gaps in the derived private sector investment series exist in the figure above because investment by public sector corporations was not recorded separately from private investment for years 1983-86 and 1992. 1.4 Structural shifts in value added at the sector level have accompanied growth in private investment (see Figure 1.2). Private sector share of value added in manufacturing rose from 41% in 1981 to 89% in 1991--the largest relative increase across sectors. The public sector, however, holds all assets in the petroleum industry and the majority of assets in the wood products, paper and printing, petroleum, and basic metals industries. And, government factories are still producing many basic products like sugar, salt, textiles, timber, paper, rubber, petroleum products, ceramics, cement and steel products. Domestic trade, banking, and transportation also report significant increases in private sector participation over the last decade. However, the two state-owned banks comprise about two-thirds of the sector's assets, and there are six major state-owned enterprises2 in the transport and communication sector. In the agriculture, exports, and construction sectors, the private sector slightly increased its already relatively high share of value-added. Only the "other" services sector experienced a fall in private sector's share of value added. The drop from 50% in 1981 to 35% in 1991 is partly due to growth of government activity in education, health and defence. The telecommunications and post sector and the utilities sector (electricity, gas and water) are under public domain (see Annex, Tables 3 and 4). These include: Air Lanka, Sri Lanka Railways, Sri Lanka Transport Board, Sri Lanka Ports Authority, Ceylon Shipping Corp. and Sri Lanka Broadcasting Corp.  - 3 - Figure 1.2: Private Sector Share of Value Added By Economic Activity (Percent) 100 eo... .... ..... ... I....... ...... 6 0 [ ..i. .. ....-......... ........... All Sectors Aqric. Maenu. Truaq,I&Ccma Trade Finance m 1981 3 1985 5 1991 Source: Central Bank B.3 PRIVATE SECTOR DEVELOPMENT: PAST, PRESENT AND FUTURE 1.5 Over the course of its history, Sri Lanka has undergone significant shifts in the roles played by the private and public sector in the economy. At Independence in 1948, Sri Lanka's economy was mainly agricultural, with a modem plantation sector and a scant manufacturing sector. Government interference in private sector activities was minimal. Over the following twenty years, the public sector absorbed or controlled an increasing share of the country's resources (see Box 1.1) and created a business climate that particularly discouraged foreign investment. Net foreign direct investment flows to Sri Lanka fell under Rs. 10 million every year between 1964 and 1978. Many domestic firms developed poor management practices under heavy government interference in which investment approvals, licensing and red tape were an everyday occurrence, workforce decisions were heavily regulated, controls on land ownership were binding, access to finance was restricted and trade incentives were biased against exporting. Box 1.1: Government Intervention in Private Markets PERIOD GOVERNMENT INTERVENTIONl early 1960s Nationalization offoreign oil companies. 1971 Enactment of the Govemment Business Acquisition Act enabled GOSL to take over any private business that it judged to be in the country's interest. 1971 Enactment of the Termination of Employment of Workmen Act granted power to the Commissioner of Labor to determine on a case-by-case basis the conditions under which private individual firms could retrench workers. 1973-75 Nationalization of tea plantations. 1970s Bank credit to private commerce and industry became heavily regulated; price controls introduced; and the State Trading Corporation was given a virtual monopoly on trade in agriculture products.  - 4 - 1.6 Following a period of poor economic performance during 1970-1977, when as much as 70% of the national economy was in the public domain, the Government of Sri Lanka (GOSL) commenced the liberalization of the trade regime and reduction of restrictions on pricing and investment in domestic markets, with a view to base economic growth on open economic policies and export-led industrial strategy. After years of excluding FDI, a new strategy to attract foreign investors was initiated with the objectives of employment generation and export growth. The key elements of this strategy were the creation of Export Promotion Zones and a set of regulations and incentive policies that enabled foreign investment to be protected or exempted from "investor hostile" policies and institutions. Real aggregate investment activity in Sri Lanka increased rapidly after the initiation of reforms in 1977 and the private foreign and domestic investors' contribution to this surge was significant. Private investment averaged 13% growth per annum within four years after reforms began. Net foreign direct investment rose from virtually zero to Rs. 1.3 billion by 1982. These actions fostered a period of rapid growth, with an average 1978-1982 GDP growth rate of 6%, led by an accelerated 13% growth of exports. 1.7 The 1977 reforms, however, were not followed by further structural reforms, particularly measures to reduce the burdensome public sector deficit. Throughout the first half of the 1980s, the public sector (including public corporations) remained the major source of real investment in the economy. The Government also employed about one-third of the nonagriculture formal sector labor force and almost all of the plantation workers. Pronounced macroeconomic imbalances emerged as a result of the large and inefficient public sector that was left intact. Exceptionally high fiscal deficits of over 10% of GDP during the 1980s led to a loss of investor confidence, which deteriorated further after the onset of the civil war in 1983. Growth of private investment, from both domestic and foreign businesses, was sluggish and on occasion negative.3 By 1986, with the current account deficit close to 10% of GDP and foreign reserves at less than two months of import requirements, Sri Lanka lost its access to foreign commercial sources of credit. Real GDP growth decelerated to an average 2.7% between 1986-89. 1.8 New impetus to reform came in 1988 with the commencement of a tariff reduction program and the elimination of import licensing for most nonagricultural products to improve the country's export competitiveness. Subsequently, the rupee was devalued in 1989. The Government's Industrialization Policy Statement in 1989 sets an ambitious goal for Sri Lanka to become a Newly Industrialized Country (NIC) within the next decade. In support of the private sector in its role as the leader of economic growth, GOSL made further progress in the areas of privatization of manufacturing enterprises, tax reform, and deregulation of economic activity. Of particular notice is the recent shift in investment policy away from the enclave strategy to attract foreign investment mainly within the Export Promotion Zones toward a more neutral and enabling regulatory environment for all investments. GOSL also made progress on the monetary front and the budget deficit fell from 11.2% in 1989 to 8.1% of GDP in 1993. 1.9 The economic rebound since the 1988 reforms has been strong and largely attributed to private sector activity (Box 1.2 illustrates recent economic trends). Private investment activity 31 Reduced government activity came from civil disturbances which occurred in areas where public manufacturing enterprises were located. The factories of the Cement, Paper, Mineral Sands, Sugar Salt and Timber Corporations, and mines and quarries were located in the north east and south of the island where communal disturbances were most intense. For exarnple, production of mineral sands fell by 40% in 1987 and 1989, indicating the magnitude of losses by state enterprises at this time.  - 5 - Box 1.2: Recent Macroeconomic Trends, 1990-1993 Growth Sri Lanka experienced strong economic growth averaging 5% per annum during 1990-92. Manufacturing and services contributed significantly to growth--increasing at 8 and 6% average annual rates, respectively. Agriculture growth decelerated in 1991; faced with severe drought in 1992, it contracted 2.3%. In 1993 overall growth strengthened to 6.9% from 4.5% in 1992, mainly because of continued strong growth in manufacturing and recovery in agriculture. Investment and Savings The steady rise in investment from 22% of GDP in 1990 to almost 26% of GDP in 1993 is exclusively attributable to private investors. Real private capital formation increase by 27% in 1992, buoyed, in part, by higher flows of FDI. FDI accounts for about 5% of total investment and 1.3% of GDP. Domestic savings reached a record high of 15.3% in 1992, up from 12.7% of GDP in 1991. Public domestic savings remained negative in 1992 at -0.6% of GDP, albeit an improvement over the -2% of GDP in 1991. Private national savings rose to 19% of GDP in 1992, largely because of increase in private foreign transfers. International Trade On average, exports grew 18% over 1990-92, with growth accelerating to 20% in 1992, owing mainly to an increase in garment exports. Service exports increased 10% in 1992, led by a 23% increase in tourist foreign exchange earnings. Under drought conditions, exports of major agricultural products, in particular tea, declined. Preliminary estimates indicate total exports are up 16% in 1993. Balance of Payments The current account deficit was reduced to 6.1% of GDP in 1992 from 7.5% in 1991 and preliminary estimates indicate a further decline to 5.3% in 1993. The overall balance at the end of 1993 is estimated at 362 Million SDR, representing the fourth successive year the balance of payments recorded a surplus. Increased FDI and foreign aid from multilateral agencies contributed to the capital inflows. At the end of 1993, reserves covered 5 months of the import requirement. Government Finance After declining sharply for 2 years, the govemment budget deficit rose from 10% of GDP in 1990 to 11.6% in 1991. The 1992 improvement to 7.4% was achieved largely through reduced development spending. Defence spending is over 4% of GDP. Domestic financing of the deficit dropped to 3.6% of GDP in 1992. Preliminary estimates for 1993 indicate the budget deficit rose to 8.1% of GDP, mainly a result of revenue shortfalls and an unanticipated increase in govemment salaries. Money and Credit Monetary expansion in 1992 was high--(M2) grew by 18% and (Ml) increased by 7%-because of high private sector demand for credit and the limited capacity of open market operations to neutralize the excess liquidity created by net foreign assets. The Govemment also had limited success in containing monetary expansion in 1993, and broad money (M2) increased by over 23%. Since 1990, credit to the private sector decelerated moderately to 20% in 1992, while the expansion of credit to the public sector, especially the Government, has decelerated substantially and tumed negative in 1991-92. The debt service ratio improved in 1993, estimated to have dropped to 13%, after hovering around 20% during 1990-92; inflows of concession loans and grants are over 5% of GDP. Prices The annual average inflation remained high at 11.7% in 1993, after a slight deceleration in 1992 from 12.2% in 1991 to 11.4% in 1992. In addition to monetary expansion, the depreciation of the rupee and an increased defense levy from 1% to 3% also contributed to inflation. The prime lending rate is rising, reaching over 20% in 1992. Labor Unemployment, hovering between 14% and 16% over the past two years, improved slightly by the fourth quarter 1992, but remained acute at 13% (excluding the North and East region). Minimum real wages in the private sector have kept up with inflation, while real wages in the state sector have declined. However, the private sector real wage index is only slightly higher than the 1980 base year. In fact, during the 1980s, private sector real wages either stagnated or dropped. Political Stability The new Govemment, headed by President Kumaratunga is committed to continued economic reformn. The smooth transition of power following the assassination of President Premadasa and a leading member of the opposition, and peaceful conduct of elections testifies to the strength of the political system. gained strength, both as a share of GDP (increasing from 11% of GDP in 1988 to almost 15% by 1991) and as a share of total investment (private sector contribution to total investment increased from 50% in 1989 to 63% by 1991). Foreign direct investment picked up, particularly during the relatively politically stable period since 1990. Based on this spurt of investment, private industrial output grew  - 6 - in 1992 by 20% in real terms, the biggest growth seen since 1985. The 1992 growth originated largely from three product categories: textiles, wearing apparel and leather; chemicals, rubber and plastics; and nonmetallic minerals. Central Bank estimates for the first half of 1993 indicate that private industrial output was up by 11% (in real terms) over the same period in 1992. (By contrast, public sector industrial output grew by only 1% during the same period). The early 1993 growth was spread across a range of industrial activities including: textiles and garments (12% growth); fabricated metal products--including cables, machinery and equipment (25% growth); nonmetallic minerals - cement, asbestos and ceramics (up 22%); the chemicals group-including rubber, plastics, paints and fertilizers (up 15%); wood products (up 25%); paper products-labels, cartons, boxes (up 15%); basic metal products (up 7%). Firms in the garments and leather products sector accounted for nearly half the overall growth in private industrial output, driven in large part by a strong export performance. 1.10 Several other indicators point to the level of buoyancy that has recently been a feature of private sector growth. Employees registered with the Employees Provident Fund (the only reliable measure of employment in the organized private sector) grew 5.5% in 1991, reaching 1.34 million. Electricity consumption in all sectors of industry is also increasing. In the first three months of 1993 compared with a year earlier, power consumption in small industry increased by 5%, in medium industry by 14% and in large industry by 9%. Expansion of domestic credit to private firms has also been strong. Between July 1992 and July 1993, credit to private firms increased by 24%, as compared with a decline in credit to the government of 12.5% and a fall in credit to government corporations of 30%. 1.11 The Private Sector Assessment (PSA) survey of 48 firms, which included listed as well as nonlisted companies, indicates that many investors plan to continue expanding and diversifying their businesses in Sri Lanka over the next few years. Overall, about 60% of the firmns surveyed have plans to diversify into new products, which would require new capital investment. Exporters more often indicate plans to diversify, compared to nonexporting firms. This bullish investment climate is consistent with the high capacity utilization rate of private sector manufacturing activities. Figure 1.3 illustrates that only the chemical and basic metal sectors, which are dominated by state-owned Figure 1.3: Capacity Utilization Rates, 1992 100 80 ... .. .. 60 / -....... 40 20- 0 Food ToztI1* Wood Paper Chem Mineral Metals Machin Otber 1986 m 1992 Source: Central Bank  enterprises, are operating below 80% capacity. And, the 1992 drop in capacity utilization in the textile sector is attributable to 200 new private garment factories, which were created as a result of government policy to direct private investment into rural areas. 1.12 The increase in private sector confidence, within the context of the on-going civil war and the decline in public sector's economic and financial drain on the domestic resource base, is encouraging. The major reversal in the roles of the private and public sectors in the economy, and the surge in private investment enabled by this restructuring, provide a basis for sustainable economic growth. Nonetheless, the impact of a long history of government intervention lingers, and many businesses in Sri Lanka are still learning the rules of modem management. To accelerate growth over the long-term, the GOSL policy reform program launched in 1989 needs to be intensified, in parallel with equally vigorous efforts to restore peace. The unfinished policy agenda to attain "NIC" status is discussed in the following chapters. 1.C. THE PROFILE OF PRIVATE INVESTMENT a. Overview 1.13 Private investment activity has shown a pickup in the past few years after being flat during the middle and latter parts of the 1980s. Contributing to private investment growth has been the increased exports of garments, new hotel and resort developments for the growing tourist trade and the establishment of new industrial estates. Upgrading of recently privatized firms and entry of private entrepreneurs into areas such as telecommunications is also adding to the upward momentum of investment growth. However, the pattern of private investment activity has not been even. Total private investment expenditure is dominated by construction activity, and since 1990 construction has been the principal source of growth in overall levels of investment. Transport equipment spending has also shown strong growth in recent years. By contrast, expenditure on plant and machinery by private firms has been variable, increasing in 1990 and 1991, and then falling sharply in 1992. Similarly, investment expenditure on land development (including planting and replanting) in the plantation sector has not shown strong growth. 1.14 Much of the physical equipment that is used by businesses in Sri Lanka is imported. In the first half of 1993, investment goods comprised the fastest growing category of imports, showing a 36% rise on the Rupee value of a year earlier. At Rs. 26.5 billion, imports of investment goods exceeded the Rs. 23.4 billion spent on consumer imports but was less than the Rs. 46.0 billion spent on intermediate imports (mainly textiles and petroleum products). The growth in imports of investment goods in early 1993 was due in part to the purchase of two airplanes for Air Lanka, but imports of machinery and equipment also rose strongly. The machinery imports were for the growing textile industry and certain infrastructure projects. In all, investment goods made up 28% of total imports, a rise from 25% in the previous year. In value terms, machinery and equipment imports remained the largest category in the first half of 1993, at Rs. 11.4 billion. 1.15 Commercial bank advances ', illustrated in Figure 1.4, indicate that most bank lending to the private sector is made by short-term loans for commercial activities. Less than 20% of About 10% of total commercial bank advances are to public corporations; however, it is not possible to distinguish advances to public corporation from advances to private companies by economic activity. And, according to monetary survey data on investment flows, less than 5% of the value of commercial bank advances is attributed to overdrafts and bills discounted.  - 8 - commercial bank advances are for long-term loans (although this figure does not account for rolling over short-term debt). Businesses engaged primarily in commercial activities receive almost 50% of commercial bank loans to the private sector, while those engaged principally in other sectors, such as industry (16%), agriculture (10%), and tourism (3%) receive substantially smaller portions of commercial bank advances (see Figure 1.5). Figure 1.4: Shares of Commercial Banks' Advances by Maturity (1992) 100 80 .... _ 60 . . .....- 20 . .... .. 1 ... ...... 0 Tbtal Agriculture Industrial Commercial _ Short Term 3 Medium Term M Long Term Source: Central Bank Monthly Bullelin Figure 1.5: Shares of Commercial Banks' Advances by Economic Activity (1992) Agrlcultural H o u sln I~~~~ndustrlal Mm 1~~~~5 Ftlnanclal 4 Commercial O 43 v Tourlsm 2 Source: Central Bank Monthly Bulletin  -9- 1.16 The sectoral pattern of funds raised through new issues and rights issues on the Colombo Stock Exchange is reasonably widespread, indicating a broad interest in new investment in a number of sectors of the economy. The manufacturing sector and tourism-related activities were the principal areas of funds mobilization on the stock market in 1992. However, the pace of growth in new corporate listings on the Colombo Stock Exchange is slow and the absence of sustained high rates of debt accumulation for longer term investment by private sector borrowers remains. b. Profile of the Investors 1.17 New Entrants in the Private Sector. According to the Registrar of Companies, Sri Lanka has around 26,000 incorporated (limited liability) companies, compared to the figure of less. than 5,000 in the mid 1980s. This comparison is, however, not accurate because the Registrar does not adequately maintain records of entry, as well as exit (see Chapter 2.G). Of the recorded recent entries, some 75% of new registrations are small to medium businesses, going into new fields of activity mainly in the services sector (e.g., business consulting, information technology, secretarial services). Examples of new manufacturing start-ups are also present. Over the past year two new producers entered the meat processing business, and exports of processed meat products have begun to grow. A new carbonated beverages plant was established in addition to expansion of mineral water production (to meet growing urban and tourist demand). The recent simplification of business licensing and approval procedures in Sri Lanka is expected to support this trend (see Chapter 2.G for detailed description of regulatory reforms). 1.18 Export-Oriented Firns. The Board of Investment (BOI) concentrates on foreign investment in export-oriented industries and relies on its powers to grant tax incentives targeted for investment in exports. In 1992, BOI approved 291 projects under special incentive schemes, bringing total approvals to 702. The total financing envisaged in BOI approved projects during 1992 was Rs. 31 billion, Rs. 18 billion of which was to be from abroad. 1.19 The number of plants under BOI registration that have commenced commercial or trial production has increased rapidly, from 153 (at end 1991) to 211 (at end 1992) to 260 (as at August 1993). Of the 211 BOI enterprises that were in commercial operation at end-1992, 125 were in the three Investment Promotion Zones and the remaining 86 were in other parts of the country. Employment in the BOI approved plants has increased from 85,000 (at end-1991) to 121,000 (as at August 1993). The majority of this employment (60% in 1992) is in the textile, wearing apparel and leather products sector. Over the past two years, however, employment in other industrial categories (chemicals, paper and food groups) has also recorded high rates of growth. Export earnings from BOI-approved investments increased from Rs. 22 billion in 1991 (27% of total exports) to Rs. 43 billion during 1992 (40% of total exports). Exports of textiles and garments (at Rs. 26.7 billion) were the largest source of foreign earnings from BOI enterprises. However, export growth is occurring in other, nontextile categories as well. Export earnings from nontextile firms grew 118% in 1992, contributing Rs. 16.8 billion to total exports. 1.20 Industrial Estate Development. Thirty four industrial locations involving 1275 ha. have been identified for development, and development of five sites has already commenced. According to the Ministry of Industries, seven investors are awaiting allocation of lands from these sites. The sites will be offered to the private sector for development. In addition, development of two large industrial estates is also underway--implementation of the 71 ha. Sithawake Industrial Estate is to be followed by the Katana Industrial Estate.  - 10 - 1.21 Foreign Investors. Sri Lanka's endowment of a relatively educated and potentially highly productive labor force remains largely under-exploited, which is partly due to the country's relative scarcity of capital and technology resources. Foreign investors help reduce this gap by bringing technology and physical and human capital to Sri Lanka. Moreover, with limited ability over the medium-term to increase Sri Lanka's national savings rate (16% in 1992), foreign capital is potentially a major source for funding investment. Sri Lanka has attracted a modest level of FDI from a wide range of countries, with the East Asian NICs predominant in recent years. A 1992 survey by FIAS of foreign investors in Sri Lanka indicates that quota availability, geographic location and the diversity of micro-climates conducive for many uses makes Sri Lanka an attractive location for investmnent. Despite these positive elements of Sri Lanka's investment climate for foreign businesses, Sri Lanka has not established large and sustained flows of foreign investment. Uncertainty regarding the extent of quotas over the long-term, policy impediments, particularly those creating labor and land market rigidities, and perhaps most importantly, the civil war, more than offset the benefits accrued by geography and natural resource endowments for many potential foreign investors. 1.22 Since the onset of civil war in 1983, Sri Lanka has attracted low and erratic levels of Foreign Direct Investment (FDI), in per capita and per GDP terms, relative to other South and East Asian countries. Although a remarkable increase in FDI occurred over the last two years, reaching US$ 119 million in 1992,5 as a share of Gross Domestic Investment, FDI remains below the 1979 5.4% peak. FDI is typically small in scale--in 1991 an estimated two-thirds of FDI were under US$ 0.5 million. 1.23 The dominant position of the textile and garment sector, in terns of total funds invested, has recently deteriorated, as a number of large property developments have helped inflate the total investment in the service sector. In 1991, the service sector received 44% of the FDI, followed by approximately 15% shares for the textile, food, and chemical sectors. Although the textile sector's share of FDI has declined both in terms of value and number of approvals, in absolute terms, the scale of textile approvals remains high. Moreover, based on employment levels, the textile sector dominates with its 51% share of employment generated by FDI, followed by services (15%), food (10%) and other manufactured products (10%). 1.24 Another feature of FDI in Sri Lanka is its weak links to the local economy through purchases of capital and raw and intermediate goods. For FDI projects that were approved by GOSL between 1978-91, only 4.2% of capital and raw and internediate goods were produced locally. Field observations conducted by the Foreign Investment Advisory Service (FIAS), of the World Bank Group, also suggest that linkages to local service markets are also relatively weak. 1.25 Relaxation of restrictions on foreign ownership of equities has opened a channel to increase the supply of investment funds in Sri Lanka. Foreign portfolio investment in the Colombo Stock Exchange began in 1989 with a modest Rs. 390 million investment. It more than tripled in 1990, partly reflecting a quick response to investment opportunities from GOSL's divestiture program for state-owned enterprises. In 1992, portfolio investment by foreigners dropped off slightly to Rs. 1121 million. Portfolio investment from abroad is about one-fifth the size of FDI. The recent increase in FDI is partly a result of Board of Investment (BOI) status for a large real estate development project and some export-oriented local enterprises.  - 11 - 1.26 The Corporate Sector. Experience from other Asian countries suggests that growth in the corporate sector will be important to the overall pace of development in Sri Lanka in the coming years. Corporate firms generally are better positioned to access both debt and equity markets to finance the investments needed to underpin growth. Established firms with sound balance sheets and a credible earnings record will most likely be able to take larger projects to the market for financing. However, relative to the size of the economy, Sri Lanka's corporate sector is not large by Asian standards. Listed companies (excluding those engaged in finance) accounted for only 8 to 9% of GDP in 1992. Similarly, the top 70 nonfinance companies (both listed and unlisted) classified according to taxation records account for around 5% of GDP.6 1.27 Only a small number of Sri Lankan companies possess the capabilities to carry on business to international standards. On the basis of SEC and Inland Revenue Service data, perhaps fewer than 20 companies (listed and unlisted) in Sri Lanka have a turnover of more than $20 million a year. These companies, and a limited number of smaller operations, appear to possess the financing and management skills needed to compete successfully with other Asian companies. Most of the more important private investment initiatives to be undertaken in the coming years will likely involve participation from companies within this group. 1.28 Beyond this relatively small group however, there are few companies with the skills needed to carry out joint venture and commercial/financial transactions of an international standard. The generally low levels of business skills tends to limit the majority of companies to short term initiatives, with too little priority being given to longer term planning and investment. Many companies in Sri Lanka receive export orders from overseas, but not all have been able to organize themselves to satisfactorily meet these orders. Development of domestic capital markets and improved international linkages are recognized as being critical to future business growth, but on their own they will achieve little until more professionalism is gained in business management. The generally narrow scope of business thinking is reflected in the large proportion of domestic investment that goes into property development. 1.29 These limitations will have an effect on the overall patterns of business financing and the pace of investment growth in coming years. At present there are a number of middle-tier companies that could approach the equity market, but their management is reluctant to do so partly because of lack of knowledge. Many of the companies who do approach the market still seek to list only a small portion of their equity, preferring to keep as much as 80% under family control. Borrowings patterns based on short term loans are also thought to be a reflection of this type of management approach (and not necessarily due to a long-term funds limitation within the banking system itself). Short-term finance is generally much easier to access than longer term finance; provided the borrower has security, there is little need for borrower or lender to pay much attention to the business intricacies surrounding the borrowing proposal. In addition, where approaches are made for longer term finance, only rarely are borrowing plans and business development plans properly worked out. In the Philippines for instance, the top 50 companies account for around 20% of GDP (and the top 1000 account for 30 to 45% of GDP). In Indonesia, the largest 400 companies account for about half of GDP while in Korea, the largest 1000 firms account for 63% of GDP. Size of the corporate sector, however, is not an indicator of economic efficiency.  - 12 - 1.30 The development of business capabilities is a priority for private sector development. A more competitive business environment (achieved through a lowering of trade barriers and freeing up of factor markets) effective programs of management training will help to encourage these changes (see Chapters 2.D and 2.H). 1.D. PRODUCT AND FACTOR MARKETS a. Industry 1.31 Structure. The private manufacturing sector consists of about 400 registered large- scale factories located mainly in the Colombo area; 6,000 small and medium factories; and about 95,000 dispersed small informal agro-industry, handicraft and industrial units. Production is dominated by garments and leather products (more than 35% in 1992), with food, beverages and tobacco constituting a significant share of the remainder. Many intermediate manufactured goods are imported. The ownership of the diverse private sector is predominantly local. The private sector holds the majority of assets in most manufacturing industries, with over 90% share in the garments, plastics, electrical goods, equipment and metal products industries. There are about 30 medium- to large-scale public manufacturing enterprises, of which 10 are in food, beverage and tobacco processing. In accordance with GOSL policy, a majority of these are in the process of being privatized. While the government's privatization initiatives have enabled increased private entry into a broader range of manufacturing activities in the period since these survey data were compiled, there remain a number of areas of activity in the manufacturing sector (such as basic metals, currently dominated by the Steel Corporation) that could be carried out by private firms. The scope for increased privatization initiatives is discussed further in Chapter 2.C. 1.32 For most manufacturing industries, concentration of value of production among firms has decreased since 1988, with the most dramatic declines in the fabricated metal, nonmetallic, and food, beverages and tobacco industries. The textile industry, the fastest growing manufacturing sector since the 1977 reforms, has the lowest concentration ratio. Despite this improvement, there is still a high degree of market concentration in the manufacturing sector. In 1992, the three largest firms accounted for 42% of total output in food, beverages and tobacco, 57% of wood products, 67% of paper products, 72% of petro-chemicals, and 98% of basic metals. Moreover, concentration in the wood and paper product industry has increased since 1988 (see Annex, Table 6). The sectors with high concentration are those dominated by public sector corporations. Large state enterprises are concentrated in cement, chemicals, petroleum, textiles, steel, and wood products. 1.33 Performance. Growth in private sector output contrasts sharply with production by public sector enterprises (see Figure 1.6). During 1977-89, private manufacturing enterprises grew (in real terms) about 13% per annum compared to 1% for public manufacturing enterprises. Private sector industry performance has been particularly strong since the 1989 regulatory reforms and recent privatization of several large manufacturing enterprises. Manufacturing value added expanded at an average 8.4% annually during 1990-1992, higher than the 6% annual growth experienced during 1982- 1989. Most of the growth in manufacturing is sourced in factory production. Export processing of plantation crops (tea, rubber and coconut), in contrast to the rest of the manufacturing sector, has declined in real terms in four of the last five years. 1.34 The textile, garnent and leather product sector is the fastest growing industry subsector in Sri Lanka, the largest export market, and has one of the lowest value added share in total value of output in industry. The sector accounts for about 30% of manufacturing sector value added.  - 13 - MOs' D.. te sector's output is produced by private sector medium-sized weavers and processors and many sima