Sri Lanka - In the year 2000 : an agenda for action

Report No. 15455-CE Sri Lanka In the Year 2000 - An Agenda for Action March 14, 1996 Country Operations Division Country Department I South Asia Region . . Documrent of the World Bank Document~~~~~ ~ ~ ~ o. the Wol Bank . ,ej-.   SRI LANKA IN THE YEAR 2000 AN AGENDA FOR ACTION TABLE OF CONTENTS Page No Executive Summary .................. i I. INTRODUCTION .............................................. I II. ACHIEVING SUSTAINED, RAPID GROWTH ............................. 3 A. Promoting Growtlh -- Interinational Experience and Lessons from the Past ............................................... 3 B. Improving Macroeconomic Management ................................ 5 C. Strengthening the Civil Service .................................. 12 D. Promoting Private Activity and Employment . ........................... 18 E. Improving Energy and Infrastructure ................................. 22 Ill. LABOR MARKETS AND EMPLOYMENT ....... ....................... 24 IV. THE AGENDA IN HUMAN RESOURCES ........ ...................... 28 A. Education ..................................................... 28 B. Health and Nutrition ............................................. 30 V. REFORMING THE SOCIAL WELFARE PROGRAMS ....... .. ............ 33 VI. SRI LANKA'S ECONOMIC GROWTH ......... ........................ 36 ANNEX .........................................................38 This report is the product of a team of Sri Lankan policy analysts and practitioners and World Bank staff. The Sri Lankan side of the team, coordinated by Dr. Lal Jayawardena (Economic Advisor to the President and Deputy Chairman, National Development Council). includes Dr. Chandi Chanmugan (Member of the Monetary Board and Institute of Policy Studies), Dr. L. Gunaratne (Director of Research, Central Bank of Sri Lanka). Dr. W. Hetteriachchi (Executive Director, Central Bank of Sri Lanka and coordinator of the Sri Lankan part of the team before being assigned to the IMF in Washington), Dr. R.M.K. Ratnayake (Secretary, Ministry of Sports, Youth and Rural Development), Dr. P. Ramanujam (Director General, Secretariat for Infrastructure Development and Investment), T. Maxwell (Consultant, Ministry of Industry) and Mr. N. Tiruchelvam (Partner. Tiruchelvam Associates). Mr. A.S. Jayawardena (Governor of the Central Bank) initially led the Sri Lankan team and guided the study throughout. Dr. S.A. Karunaratne (Director General, National Planning Department), the staff of the Planning Department, Dr. P.B. Jayasundera (Deputy Director of Research, Central Bank of Sri Lanka), Dr. S. Kelagama (Executive Director, Institute of Policy Studies) and Dr. Sisiva Jayasuniya (Professor of Economics, University of Melbourne), all deserve special thanks for their thoughtful comments. On the World Bank side, the team included P. Alba (Task Manager), S. Lateef. M. Prywes, C. Hartler, R. Nangia, A.G. Karunasena, V. Iyer and C. Kanda.  Page No LIST OF TABLES Table 1: Adjustment and Growth in Sri Lanka ......... ........................... 4 Table 2: Overview of the Labor Market .. ...................................... 25 Table 3: Uneinployment Rates by Group: Q4 1993 ................................ 26 Table 4: Key Economic Indicators Under Adjustment .............................. 39 LIST OF FIGURES Figure 1: Fiscal Sustainability ................................................. 8 Figure 2: Projected Incidence of the Wheat Flour Subsidy in 1995 ...................... 35 LIST OF BOXES Box 1: Economic Adjustment, Growth and Income Inequality. 2 Box 2: Thle Benefits of Macroeconomic Stability. 6 Box 3: Capital Flows and Macroeconomic Policy. 9 Box 4: Building a Structure for Stability .10 Box 5: Building Institutions: The East Asian Experience .13 Box 6: Report of the Administrative Committee - Extracts .15 Box 7: Finanicinig Higher Education .31 Box 8: Back to the Future - Evolution of Targeting of Social Transfers .34 Box 9: Successful Targeting of Social Transfers in Developing Countries .36 BIBLIOGRAPHY  EXECUTIVE SUMMARY Introduction 1. Sri Lanka has achieved remarkable success in human development. The level of social development, as measured by key indicators such as life expectancy and adult illiteracy rate, is well ahead of other countries at similar income levels, and stands out even compared to middle-income countries. While good initial conditions helped, Sri Lanka's success is mainly the consequence of continuous emphasis on human development since Independence, including a tradition of providing generous safety nets. 2. That success has not been fully matched on the growth side. While Sri Lanka's long-term per- capita growth has been good (about 2.8% p.a. on average between 1961-93) compared to other low income economies, it has been below potential. While Sri Lanka emphasized education and health like the more successful of its East-Asian neighbors, stop-and-go economic policies have had a dampening effect on growth and the ability to utilize fully its human resource base. Indeed, growth is the weak link in Sri Lanka's poverty alleviation strategy. A stronger growth performance comparable to the more successful Asian economies would have led to deeper reductions in poverty whose incidence remains of deep concern. In spite of recent gains in growth and employment, it is estimated that in 1990 some 20% of Sri Lankans lived in absolute poverty. 3. And tragically, that success has been marred by a tragic ethnic conflict that has exacted a high cost in human lives and suffering and has directly and indirectly severely sapped growth prospects. The war has caused large scale destruction of economic and social infrastructure, reduced private sector confidence and investment, reduced foreign exchange revenue, and has diverted a large proportion of national resources into military uses. 4. The recent changes in Sri Lanka's political scene has opened new opportunities for taking a fresh look at Sri Lanka's development challenges and elaborating a responsive strategy. Most positively, the Government has taken courageous steps to seek to end the war, even if these efforts have been frustrated. While the recent renewal of hostilities is a terrible blow to the peace process, the Government remains committed to a negotiated settlement. Peace would set the stage for a sustained economic boom if complemented by appropriate development policies and programs. These should serve the Government's objectives to boost growth and employment, and preserve Sri Lanka's edge in human development which would also help ensure widespread distribution of the benefits of rapid growth. 5. This report, a product of a team of Sri Lankan analysts and World Bank staff, elaborates policies to address how to increase the growth rate, including strengthening macroeconomic management, removal of obstacles for private sector development, and raising the efficiency and implementation capacity of the public sector. On the human development side, the report looks at how to increase employment in a sustainable manner, and improve the quality of basic human services and the targeting and cost-effectiveness of poverty progranms. The matrix attached to this Executive Summary enumerates the main policy recommendations of the report. Raising the Growth Rate 6. To strengthen growth, the Government's priorities are to achieve lasting peace and resume adjustment efforts. It is difficult to over-rate the consequences of peace. In a nutshell, peace is essential to sustain private confidence in Sri Lanka's economic prospects, to restore the productive capacity of the North and East, to fully exploit tourism potential, and to reduce macroeconomic imbalances and release resources towards productive uses. Without peace, Sri Lanka is unlikely to emulate its dynamic East Asian neighbors.  - ii - With the advent of peace, the growth potential will increase dramatically. However, the peace dividend in the short-term will likely be small, and increase only to the extent that longstanding policy deficiencies are tackled. These weaknesses are made more acute by the large fiscal slippages and the lack of progress in implementing structural reforms during the election year of 1994. 7. The Main Constraints. A review of Sri Lanka's economic performance suggests that the most important of these policy areas are weak macroeconomic management, rigid and distorted regulatory, legal and incentive environments for private sector development, and inappropriate agricultural and financial sector policies. An emerging issue is the capacity of the public sector to build a supportive institutional framework. Successive governments in Sri Lanka have tackled these constraints with halting resolve through macroeconomic adjustment measures and structural reforms. Since 1989, renewed efforts have led to major improvements in economic performance, including a sharp rise in per-capita income growth, a large increase in national, especially private, investment and savings, and a significant improvement in Sri Lanka's external position through accelerated export growth and an increase in private capital inflows. These exceptional improvements underscore both the potential for East-Asian growth levels and the need to complete the reform program and reverse the 1994 slippages for Sri Lanka to achieve that potential. 8. Improving Macroeconomic Management. Along with peace, macroeconomic stability is Sri Lanka's most urgent yet difficult task. Two macroeconomic management issues stand out in Sri Lanka. First, Sri Lanka's record on inflation is not strong, despite frequent interventions by government to moderate increases in the prices of sensitive commodities. Inflation, as measured by the Colombo consumer price index, averaged 12% p.a. during 1980-95, with considerable fluctuations (2% - 26%). The second source of concern is the large and growing overhang of public domestic debt (about 43% of GDP at end-1994). Interest payments have become a heavy burden on the budget, representing some 20% of central government expenditures or some 6% of GDP in 1995 up from 2% of GDP in 1970. 9. Fiscal Policy. The key to achieving macroeconomic stability in Sri Lanka is to sharply reduce the budget deficit, which directly and/or indirectly is a primary cause of inflation, rising public debt and high real interest rates. The deteriorating debt indicators and other factors suggest the need for urgent fiscal adjustment, including negative public savings since 1988, a large primary (net of interest) deficit, and high domestic financing requirements in the order of 4%-6% of GDP (25 %-35 % of national savings in 1993-95), that are incompatible with moderate inflation and high growth objectives. The medium-term objective for fiscal policy is to reduce the deficit to about 5 % of GDP, followed by further consolidation to approximately 3% of GDP by the year 2000. This deficit target is equal to approximately what can be financed by foreign concessional loans and grants and is sustainable, given inflation and growth objectives. The challenge for Sri Lanka is how to achieve these targets. 10. Raising Revenues. On the revenue side, Sri Lanka's tax effort, some 18%-20% of GDP, is on the high side for its per-capita income, and increasing tax revenues further will mainly be a gradual process of improving administration. Structural measures will be mostly directed at improving the buoyancy, efficiency and equity of the tax system rather than directly increasing revenues. The best prospects to increase revenues lie in eliminating tax waivers and exemptions, and in the non-tax area by raising cost recovery in public services. Given implementation constraints, rail, electricity, and petroleum products are areas where cost recovery can be increased in the short-run to be followed by irrigation, education and health. 11. Reducing Expenditures. Notwithstanding these revenue efforts, in the medium-term most of the fiscal correction will have to be achieved through expenditure rationalization. In order not to compromise social and growth objectives, key capital and recurrent expenditures in priority areas such as education, health, and infrastructure, including more adequate provisions for operations and maintenance, would be protected.  - iii - Indeed, government capital expenditures have declined sharply in recent years (8% of GDP in 1995) because of pressures to meet deficit targets in the face of rising current expenditures. 12. Hence, much of the adjustment will need to come from the current budget, especially by restraining the wage and pension bill (8% of GDP in 1995) and, in general, improving the cost-efficiency of the public sector. Privatization and promoting private investment in infrastructure will reduce transfers to state enterprises and satisfy critical needs with generally greater efficiency and without straining public resources. tUsing privatization proceeds to retire expensive domestic debt would generate indirect savings and 'fiscal space' for human development through lower interest payments. Significant savings in welfare programs and subsidies (3% of GDP in 1995) and more effective poverty reduction could be achieved through improved targeting to the poor, as described below. Defense expenditures could be cut back when peace is secured (increased from 3% in 1990 to 5% of GDP in 1995). In the short-term, the priority should be to: (i) restrain hiring, especially in the teaching corps; (ii) eliminate unproductive subsidies; and (iii) accelerate the privatization program. Along with these measures, Sri Lanka should also consider institutional mechanismns that reduce the capacity of the government to adopt profligate fiscal policies. Increasing the independence of the Central Bank is one option that has worked well in many other countries. 13. Public Administration Reform. A reform of the civil service will be at the heart of the efforts to improve the efficiency of the public sector, and effect savings. It is also essential to build an institutional framework supportive of well functioning markets and the private sector. Four areas are critical to the reform process: (a) shedding activities that could be done better by the private sector, focussing scarce public sector capacity to deliver quality services where markets do not work well (e.g., law and order, primary education and health, and safety nets); (b) reinforcing the public sector's regulatory and policy functions so it can better manage a market economy; (c) in conjunction to the peace process, developing and implementing a coherent approach to decentralization; and (d) discharging functions in a fully transparent manner, with clear systems of accountability. Political interference, feather bedding and the use of appointments for political patronage have resulted in over-staffing, especially at lower levels, and reduced morale and effectiveness. 14. Thus, the program will include a review of the composition and management of the civil service, as well as a parallel review of the structure of government. The latter would mainly entail a re-assessment of the size and functions of the public administration with the view of eliminating or downsizing units with obsolete or less important functions. The main staffing implications of the reform are a reduction in numbers, a redeployment to priority functions within a redefined role of the state and to lower levels of government, and the acquisition of new skills. Given the medium-term nature of the programme, the short-term impact is likely to be small. Redundant staff should be compensated. When staff numbers are reduced, the compensation package for higher level civil servants should be made more competitive. The short-term priorities are: (a) to limit hiring strictly, including canceling unfilled positions; and (b) to make a high profile central unit responsible for the reform with full political backing. 15. Enhancing Accountability. Financial accounting, reporting and auditing systems are unable today to ensure accountability in government. While the systems are considered well designed, implementation weaknesses compounded by a gradual erosion in political oversight have led to a loss of financial control. In particular, there are in-ordinate delays in submitting and auditing accounts, as well as in following-up on recommendations. For example, the audits of externally financed projects are too often completed with more than one year delay. To restore financial accountability, the immediate priorities are: (a) to insist on prompt and complete financial reporting and auditing according to a code of conduct for accountants and auditors; and (b) revitalize the role of the parliamentary Public Accounts Committee. These measures would be complemented in the medium-term by strengthening the staffing of accountants and auditors, including adequate training and modern automated systems.  - iv - 16. Reducing Corruption. Another government priority is reducing corruption, in part because of recent serious cases, such as one involving the purchase of buses for the "peoplized" bus companies. The Government's initial reaction has been to strengthen the law and establish an independent investigative commission. However, experience in other countries suggests that these initiatives work best when complemented by a broad range of measures strengthening institutions and dealing with the underlying causes. Such measures include reinforcing financial accountability, restoring a professional and competitively paid civil service, and adopting more transparent procurement procedures based on competitive bidding and standardized documents. Finally, trade and tax reform (limiting discretionary powers and adopting lower and more uniform rates), privatization and deregulation would reduce opportunities and incentives for corruption and promote private activity and employment. 17. Promoting Private Growth and Employment. Sri Lanka's historical experience demonstrates the importance of market friendly environment for private activity. Against the backdrop of misguided policies in the 1960s and 1970s, the response of the economy to the reform efforts during 1980-1990 has been strong. At this point, four policy areas seem most critical: completing the reform of the trade and tax systems, addressing key structural weakness in agriculture, further financial sector reform, and improving infrastructure. In the medium-term, strengthening the legal framework is also important. Labor market issues are looked at further on below. 18. Trade and Tax Policy. The thrust of the Government's program in this area is to increase competition and eliminate distortions through tax and tariff simplification and by reducing protection. The trade reform program in manufacturing is far advanced and should be extended to agriculture. The short-term priority is stabilizing the degree and nature of agricultural protection, eliminating quotas, to be followed by a reduction in protection over the medium-term. Replacing the distortionary sales tax and many excise duties with a VAT, planned for 1996, is the priority for domestic taxes. 19. Agricultural Policies. Productivity growth in the plantation and non-plantation crop sectors has been slow in Sri Lanka, and in both cases the inefficient use of land explains much of this weak performance. In 1992, management of the state plantations was transferred to the private sector through 5 year lease contracts. However, given the long lead time and scale of the replanting and other investments required, private capital will not be forthcoming until investors are given a larger stake and longer time horizon. Outside of plantations, agricultural potential and incomes are being impaired by restrictions in land use and ownership. Elimination of these restrictions would benefit farmers as they take advantage of more profitable opportunities. Although essential, eliminating these land restrictions will be process intensive and take time to complete. 20. Financial Sector Reform. The high cost of finance and the narrow range of financial instruments are important obstacles to economic expansion and diversification. Factors that lead to high interest rates are large public sector domestic financing requirements, an inefficient banking sector, the ethnic war, and weak financial savings as evidenced by the low deposit to GDP ratio. The most important action to improve efficiency in the financial sector is to privatize the two large, inefficient state owned banks which control a market share of about 60% of both sides of the balance sheet. These banks have large losses and weak portfolios. Another area that needs attention are the regulatory and institutional deficiencies constraining the development of debt markets, in particular secondary markets for treasury securities. Reforms of immediate priority are to review the restrictions on investments by the two state pension schemes and to allow primary dealers to hold treasury securities on their own account. 21. Improving Infrastructure. In both quality and quantity of infrastructure, Sri Lanka is behind many of its South East Asian neighbors. These deficiencies arise from the chronic operational weakness of the public agencies in the infrastructure sector, and from the public sector's flimsy financing capacity. To deal with these problems, the government is trying to attract private resources and management into the sector, through private  - v - ownership, BOT arrangements and partial equity sales, and to enhance the efficiency of public agencies in infrastructure. The short-term priority is to make the arrangements for encouraging and negotiating BOO/BOT agreements more effective, especially dealing with the lack of commitment to such agreements in public utilities and line agencies. Another priority is to proceed expeditiously with the privatization of key firms such as Air Lanka and Sri Lanka Telecoms. International experience indicates that privatization will increase efficiency in the delivery of these essential services and hence encourage growth. In the case of Air Lanka, privatization would help prevent losses and raise additional revenues. Completing successfully a privatization or a BOT deal would have the extra benefit of cementing private confidence in government commitment to market friendly policies. 22. Strengthening the Legal Framework. The Sri Lankan legal system has several deficiencies with regard to enforcing property rights and contracts. Among the most important issues with financial or economic implications are: (a) the weak enforcement capacity of the legal system, including long delays in resolving litigation in both courts and alternative dispute settlement mechanisms, poor court and property records, and weak training of judges on business and economic matters; and (b) dated laws that have not kept up with changes in business practices and the development of new products and policy instruments, including in financial and labor markets. While critical in the long-run, most actions to be taken in this area, including training of judges, expansion of the number of courts, improvements in other dispute settlement mechanisms, and review of legislation, are of medium-term nature. Human Development 23. Two of the Government's main objectives are to preserve Sri Lanka's edge in human development and ensure that the benefits of growth are shared widely, especially by the poor. To this end, the Government is relying on two win-win mechanisms that are not only key development objectives in their own right, but based on international experience are also critical for long-run growth and equity. While these mechanisms varied from country to country, they emphasize increasing opportunities for up-ward mobility and targeted poverty programs, rather than, for example, across the board commodity subsidies. First, a key win-win mechanism is to ensure wide access to basic education and to essential health services. The second mechanism is to maximize the employment creating impact of growth. The Government is complementing these mechanisms with a thorough review of its safety net programs. 24. Human Capital - Capitalizing on Past Efforts. Given its excellent achievements in this area, the challenge Sri Lanka faces is to maintain and further develop human resources, and complement the quantitative successes with quality improvements that a modernizing economy will require. In both health and education, the overall resource constraints are severe in the short-term, and the emphasis is more on using resources effectively. 25. Education. Several indicators, including weak examination results and complaints by employers on the qualifications of applicants, suggest that improving quality in the education system is a key priority. Another issue is the capacity of university system to satisfy growing demand for higher education and for producing practically oriented graduates trained for jobs in private business. To improve quality in primary and secondary schooling, the priority action is to stop massive recruitment of untrained graduates as teachers. The emphasis rather should be on training of teachers, on initiating a rational teacher deployment policy, and providing quality education inputs. At the university level, the priority is to give the system a more practical orientation and to introduce cost recovery in a gradual manner to raise additional resources, while ensuring that low income students continue to have access to higher education. At all levels, a stronger emphasis on English training is essential for a society with a growing technological and international orientation.  - vi - 26. Health. Overall, Sri Lanka has good and well functioning public health services with wide coverage. The main issues are chronic child malnutrition, a resurgence of malaria, and overcrowded tertiary facilities. Reallocating public expenditures from tertiary services to primary facilities and to preventive health is the priority action in health, helping to resolve both the overcrowding and malaria issues. The overcrowding at tertiary level partly reflects the decline in quality in primary facilities that resulted from decreased allocations of money and drugs. With regard to malnutrition, information campaigns on appropriate feeding practices during weaning would have the greatest impact. 27. Reducing Unemployment. Increasing job opportunities, especially for the young, is very high on the Government's social and economic agenda. First, as noted above, a well functioning labor market is critical for poverty alleviation. In addition, open unemployment, about 12% in 1995, is high and a significant source of social tension. Youth violence and discontent has been a serious recurring political and social problem in Sri Lanka, as evidenced by the JVP uprisings. However, reducing unemployment while at the same time providing jobs to new entrants to the labor force will require both strong economic growth and highly flexible labor markets. 28. The Structure of Labor Markets. Sri Lanka's labor markets are divided into a protected or privileged sector, a less regulated sector and the state plantations. The protected sector, about 25% of the employed workforce, consists of the civil service, and employees of public enterprises and some large and medium-scale private enterprises. Employees in this sector receive numerous wage and non-wage benefits that are set or regulated by the government, including wages generally above those prevalent in the less regulated sector, participation in generous pension schemes, long holidays, and an enhanced job security. In particular, the Termination of Employment Workmen Act (TEWA) prevents employers from laying-off workers for non- disciplinary reasons, including downsizing for financial reasons, without, in practice, the agreement of the workers themselves. Hence, these rules usually oblige firms to offer large settlements. 29. Policy Options to Reduce Unemployment. These benefits motivate long-lasting search for jobs in the privileged sector by the young and well educated, who constitute some two thirds of the unemployed. Hence, measures that reduce differences in the labor market will reduce unemployment. Two measures are of top priority: (a) stop massive hiring into government that encourages workers to wait for government jobs rather than accept offers in the less regulated sector; and (b) amend the TEWA to reduce labor restructuring costs for enterprises in financial distress. Such an amendment would probably increase turnover but would reduce labor costs and boost employment overall, and would, by providing easier entry into the job market, reduce youth frustration. To help the poor and less educated, an option is to expand public expenditures in high return labor intensive areas (e.g., road maintenance) as part of a well targeted safety net program. There is in addition a need to bring employers and workers into a partnership with the Government to foster growth and employment. 30. Targeting Safety Nets. Because of ineffective targeting, Sri Lanka's safety net programs transfer relatively modest sums to a large fraction of the population rather than adequate sums to the very poor. They are a significant budgetary burden: the estimated annual cost of the transfer programs and the flour and fertilizer subsidies is around 3.5% of GDP. However, the real value of transfer levels to the poorest households are not as high as they should be. 31. Recent Initiatives. Sri Lanka has improved targeting of these programs over the past 15 years. The Government intends to consolidate the food stamp, mid-day meal and main Janasaviya programs into a new and better targeted program called Samurdhi. Samurdhi is intended to benefit some 1.2 million households (about 30%) compared to the 1.5-1.6 million receiving food stamps and the untargeted mid-day meal. Samurdhi participants will receive a monthly transfer of Rs. 500 (the extreme poor Rs. 1000), a significant increase. The net effect will be to raise the poor above the minimum poverty threshold. However,  - vii - there have also been serious setbacks. In particular, two new commodity subsidies, on wheat flour and fertilizer, were introduced in 1994 that are not targeted. Indeed, the flour subsidy is very regressive. Based on the 1990/91 household expenditure survey, the 20% richest households will receive about 32% of the subsidy while the poorest 20% receive only 9%. 32. Improving Targeting. The priority measure in this area is to eliminate as quickly as possible the regressive wheat flour subsidy as well as the fertilizer subsidy. The Government could consider increasing Samurdhi benefits by some Rs. 400 million (the estimated value of the flour subsidy going to the poor), to ensure that real incomes of the poor do not suffer. Important but of less priority is to eliminate "interest payments" of Janasaviya, now received by some 400 thousand beneficiaries. While maintaining constant the total number of households at 1.2 million, Janasaviya households should be screened and incorporated into Samurdhi. Other untargeted programs (e.g., free school uniforms) should be discontinued. 33. Winners and Losers. Identifying short-term winners and losers helps the Government assess the need for mitigating measures. In the long-term, the Government is confident that the combination of higher sustained growth, wide access to good quality social services and a decline in the unemployment rate should increase living standards across the board. 34. The Poor. The poor, basically those households in the lowest three income deciles', will be net beneficiaries from the reform program. Fundamentally, better targeting of the safety net programs will result in a significant increase in transfer levels. Based on data from the 1990/91 expenditure survey, the average income of households in the first decile would increase by about 21 % (in 1994 prices) with a transfer of Rs. 500/month. In addition, the decline in prices of essential foodstuffs resulting from the gradual reduction in protection would also benefit the poor. This result holds true even for rice since, according to the same survey, about 90% of households in the two lowest deciles are net consumers of rice. Increased expenditures on roads and other labor intensive activities, in particular for operation and maintenance, should increase the demand for unskilled labor. Despite this overall positive evaluation, some important caveats apply to protect the poor fully. Basic education and health should be protected from cuts, while cost recovery should be carried out with due regard for the poor, for example, by needs based scholarship programs or electricity life lines. 35. Overall, plantation labor, among the poorest groups, will likely also benefit in the short-term from the program. One problem is that, at current output levels, the demand for additional worker in some plantations is estimated to be less than the labor surplus in others. However, the proposed reforms, by attracting capital to the sector, would be beneficial to workers as employment opportunities and productivity grow. In addition, as in other privatization transactions, the Government will transfer a 10% equity share of the management companies to workers. In addition to being pro-poor, this has the benefit of demonstrating in a tangible manner how minorities can share in the benefits of development. 36. The Middle Class. The net impact on middle income groups of the non-budgetary measures of the reform program is likely to be positive. Based on past experience, it is likely that the privatization program will not lead to significant job losses. The increase in labor demand derived from the output expansion that could accompany privatization and private investment could more than compensate for existing overstaffing. In addition, the proposed labor market reforms will be particularly positive for the relatively educated. However, some short-term losses can be expected as a result of the civil service reform, and the restructuring and targeting of social sector programmes (including education) to benefit the poor. In addition, further research on the distributional impact of the proposed cost recovery measures would help assess the need for mitigating measures, although increases in the more sensitive areas will likely be gradual. I Each decile represents an income group composed of 10% of the population.  - viii- PoUicy Matrix: Sri Lanka: Agenda for Year 2000. Area Short-Term Medium-Term Reasons Measures Measures L POLICIES TO STRENGTHEN SUSTAINABLE GROWTH 1. Government Expenditure: Increase public savings and BudEet - Strictly limit hiring into public sector. - Implement civil service reform. reduce fiscal deficit, in order to make adequate savings available to the private sector. Improve efficiency of public expenditures. - Eliminate commodity subsidies. - Use privatization proceeds for retirement of debt. - Implement reform of govenmment pension system. - Increase expenditures for operation and maintenance in key sectors. Revenue: Increase public savings and - Increase cost-recovery in rail, - Increase cost-recovery for other public reduce public sector deficit. electricity, and petroleum products. services such as higher education, Increase efficiency in health, irrigation, water, and resource allocation. telecomunications. - Eliminate tax exemptions and concessions. - Introduce PSI. - Improve tax administration. Increase direct tax revenue. 2. Exchange Rate - Maintain a stable and competitive - Maintain a stable and competitive Maintain extemal Polcv. exchange rate. exchange rate. competitiveness. 3. Public - Limit new hiring and cancel unfilled - Implement civil service refomm . Improve the effectiveness Administration positions. and efficiency of the public Reform sector. Effect savings. - Establish oversight mechanisms for implementing civil service reform. - Institutionalize prompt and complete - Improve staffing and training of Improve accountability and financial reporting and auditing. accountants and auditors. reduce corruption in Govemment. - Revitalize the role of the parliamentary Public Accounts Committee. - Adopt transparent and streamlined procurement procedures based on competitive bidding and standardized documents.  - ix- Area Short-Term Medium-Term Reasons Measures Measures 4. Trade and Tax Increase competition and Reform External: - Adopt a uniform tariff of 15 percent eliminate distortions through by 1998 in manufacturing. tax and tariff simplifications. - Adopt more stable protection level and - Reduce protection in agriculture, system in agriculture. Eliminate including for paddy, eliminating anti- quantitative restrictions. export bias. Internal: - Replace sales tax and excise duties - Continue to rationalize tax with a revenue-neutral VAT. concessions granted by BOI and move toward moderate direct tax regime. 5. Financial Sector - Begin to privatize Bank of Ceylon. - Complete Bank of Ceylon and Improve efficiency of Reform privatize Peoples Bank. financial intermediation and promote private savings. - Review restrictions on investments by - Establish auctions of medium- and the Employees Provident Fund and long-term govemment debt. Employees Trust Fund. - Allow primary dealers to hold treasury - Encourage establishment of rating securities on their own account. agencies. - Further open the capital account, including: (a) Institute more automatic mechanisms to authorize firms and banks to raise capital in international debt markets. (b) Review the appropriateness of current prudential ratios, and reinforce the supervision of financial system. 6. Legal Reform - Revitalize Law Reform Commission. - Strengthen enforcement capacity of Improve institutional legal system by improving quality and framework for private efficiency of courts, altemative dispute activity. settlement mechanisms and institutions such as property and company registrars. - Review legal system including completing ongoing reform of the Companies Act, followed by labor laws, bankruptcy laws, etc. 7. Aericulture Plantations: Increase productivity in the - Implement longer term land leases. agricultural sector. - Privatize the plantation companies. - Stop govermment interference in collective bargaining. Non-plantations: - Eliminate restrictions on land use and ownership. - Regularize land titles. - Eliminate monopoly power of CWE, especially wheat marketing. - Free up input, (e.g. fertilizer ) and output (e.g. rice) marketing, including private sector participation of CFC and PMB.  x - Area Short-Term Medium-Term Reasons Measures Measures & Infrastructure - Increase commitment to BOO/BOT in - Review roles of line and special Attract private resources an public utilities and line agencies. agencies to attract private investment. management into the sector - Begin privatization program, starting - Expand privatization efforts, with Air Lanka. especially to telecom and power. - Resolve regulatory issues to manage private provision of services. - Set-up long-term debt fund to supplement private debt and equity capital. HUMAN DEVELOPMENT 9. Labor Market - Stop massive hiring into government - Amend TEWA and other labor laws. Reduce unemployment and (see above). increase flexibility in the labor markets. - Expand public expenditures in high- return and labor intensive activities such as O&M and rehabilitation of roads (see above). 10. Education - Stop massive recruitment of untrained - Train the large number of untrained Improve quality in educatio: graduates as teachers. Implement teachers and provide quality education services. teacher deployment program. inputs. - Give the university system a more demand orientation. - Introduce cost-recovery in higher education. 11. Health - Carry-out information campaign on Reduce malnutrition. appropriate feeding practices during weaning period. - Reallocate public expenditure from - Introduce cost-recovery in tertiary Improve public health. tertiary to primary facilities, and care. preventive care. - Formulate a policy on the division of labor between the public and private sector. - Begin implementation of anti-malaria campaign. 12. Social Safety Net - Consolidate "interest payments" of - Improve screening techniques. Enhance the effectiveness ol Janasaviya into a new better targeted the social transfer programs program (Samurdhi). in supporting the poor. - Eliminate wheat and fertilizer subsidies.  SRI LANKA IN THE YEAR 2000 AN AGENDA FOR ACTION I. Introduction 1. The newly elected Government in Sri Lanka has high hopes that during its 6-year mandate (ending in the year 2000) it can significantly improve the quality of life of every Sri Lankan. It has a vision of a peaceful, prosperous and just Sri Lanka, in which all, irrespective of ethnic origin, religion or income status, are working together to raise individual and collective prosperity. An essential element of this vision is a rapid and sustained increase in economic activity to provide the jobs and opportunities to eradicate poverty and promote human development. In a sense, the Government's vision is that of a more gentle and caring East Asia, in which the rapid economic growth of the East Asia experience is combined with the traditional emphasis of the Sri Lankan policy on poverty alleviation and human development. 2. Indeed, Sri Lanka's greatest asset to achieve this vision is its remarkable success in human development. The level of social development is ahead of other countries at similar and even higher per- capita income levels. For example, Sri Lanka has better indicators of life expectancy, infant mortality, adult literacy, and secondary school enrollment that Indonesia and Malaysia, two of the more dynamic countries of South-East Asia. This success is the result of continued investment in health and education that have sharply improved already good initial social indicators. The challenge is to maintain and advance Sri Lanka's edge in human development. 3. There can be no doubt that achieving lasting peace is essential for this vision. It is the single most important challenge faced by the Government. Without peace, whole regions of the country and many members of the Tamil community will not be able to share in the benefits of development. And without peace, it is doubtful that Sri Lanka will be able to emulate its more successful Asian neighbors in terms of economic growth. The Government has rightly placed peace first in its agenda and has taken courageous steps to end the war, opening negotiations with the LTTE. While the recent renewal of hostilities is a terrible blow, the Government remains committed even today to a negotiated settlement. 4. Another key challenge faced by the new Government is improving Sri Lanka's long-term growth performance. During 1961-93, Sri Lanka's per-capita GDP has expanded at an average annual rate of 2.8%, approximately the same as the average growth rate for the low income economies during 1965-90. While this performance is good, it is below potential, especially taking into account Sri Lanka's wealth of human capital. With a per-capita income of about US$ 600, Sri Lanka remains a low income country some 50 years after Independence. The World Bank's Poverty Assessment' estimates that one out of five Sri Lankans was poor in 1990, when measured against a consumption poverty line close to the "one-dollar- a-day" absolute poverty benchmark.2 These numbers are in sharp contrast to the social indicators. 5. Given excellent human resource indicators, and the traditional generous public and private safety nets, growth is the weak link in Sri Lanka's poverty alleviation strategy. Other factors remaining equal, a stronger growth performance comparable to that of the more successful Asian economies would have led to deeper reductions in poverty. It is increasingly recognized in Sri Lanka that poverty is not a localized phenomenon, and that lasting and rapid declines in poverty require broad based, high and sustained growth based on the private sector. This is the only realistic way to create more and better paying jobs, and to increase income and consumption for the majority of the poor. I World Bank, Sri Lanka - Poverty Assessment, (1995). 2 Per-person in 1985 purchasing power parity.  - 2 - 6. Another concern of the new Government is that indeed the benefits of growth are shared widely, in particular by raising employment and preserving Sri Lanka's edge in human development. The experience of other Asian countries demonstrates that all income groups, including the poor, can benefit from rapid private sector led growth (Box 1), if the policy framework is appropriate. According to the Poverty Assessment, in Sri Lanka income distribution in 1990 was roughly the same as that of the early 1950s, implying that the tripling in real per-capita consumption during this time period has been shared by all income groups. The emphasis on human development cannot be unrelated to this favorable result. Box 1: Econonmc Adjustment, Growth and Income Inequality Some analysts believe that while the process of economic liberalization and adjustment can result in rapid economic growth, it brings little benefit to the poor because of the negative impacts of such policies on income distribution. However, there are many examples of developing countries that suggest otherwise, that rapid private sector led growth is compatible with relatively lower levels of income inequality. The experience of the dynamic Asian Economies (Hong Kong, Indonesia. Korea, Malaysia, Singapore, Taiwan [China] and Thailand) is particularly relevant in this regard. They have achieved unusually low and declining levels of inequality and high per-capita growth rates. In particular, in these countries: Income inequality (as measured by the ratio of the income shares of the richest 20% and the poorest 20% of the population) is among the lowest of developing nations. The East-Asia Miracle study ranks forty countries by the income inequality ratio and per-capita GDP growth during 1965-89. Of these forty, only the seven countries mentioned above had low inequality ratios (below 10, in the same range as OECD economies) and per-capita growth rates above 4% p.a.. While most South-Asian economies, including Sri Lanka, had low income inequality ratios, growth performance has not been nearly as strong. Income distribution (as measured by Gini coefficients) has improved between the 1960's and 1980's. In fact, according to the East-Asia Miracle study, improvements in income distribution in the dynamic Asian economies generally coincided with periods of rapid growth. These favorable outcomes were partly the result of policies and initiatives to increase opportunities for all to share in the benefits of growth. While these mechanisms varied from country to country, in these seven countries they emphasized increasing opportunities for upward mobility rather than granting direct income transfers or subsidizing specific commodities. The mechanisms/policies included wide access to primary and secondary education, land reforms, support for small and medium-scale industries and public support for low-income housing. In addition, where relevant, these countries adopted policies favorable to agriculture, leading to rapid increases in agricultural productivity and rural wages and incomes. raising living standards in rural areas where initially the majority of the population resided. Source: World Bank, The East-Asian Miracle (1993). 7. The purpose of this paper is to elaborate a medium-term policy framework to achieve the Government's development objectives in an effective and sustainable manner. It is based on the two economic policy statements of the Government3, but attempts to more concretely explain mechanisms and policies to achieve the Government's goals in important selected areas. It focuses first on a set of policies to address how to raise the growth rate (section 11), including: (a) strengthening macroeconomic management, (b) promoting private activity through improvements in the incentive and legal frameworks, and by policy reforms in agriculture, the financial sector, and infrastructure; and (c) raising the efficiency Economic Policy Statement of the Government of Sri Lanka, by the Hon. Chandrika Bandaranaike Kumaratunga, Prime Minister of Sri Lanka, Colombo, Sri Lanka, September 13, 1994. Policy Statement of the Government of Sri Lanka on the Occasion of the Opening of Parliament, by H.E. Chandrika Bandaranaike Kumaratunga, President of Sri Lanka. Colombo, Sri Lanka, January 6. 1995.  - 3 - and implementing capacity of the public sector. The paper then turns to policies to further advance human development in Sri Lanka and ensure widespread distribution of the benefits of growth. In particular, it looks at how to increase employment (section 111), how to improve the quality and productivity of basic social services (section IV), and how to improve the targeting and cost effectiveness of the poverty programs (section V). II. Achieving Sustained, Rapid Growth A. Promoting Growth -- International Experience and Lessons from the Past 8. In order to eradicate poverty and unemployment, a fundamental objective of the Government is to increase the rate of income growth in a sustainable manner. Despite similar initial conditions. Sri Lanka's long-run performance has been much weaker than the high performing Asian economies. For example, while real GDP p.c. increased in Sri Lanka by 2.8% p.a. on average during 1961-93 (Table 1), it increased by 3.4% p.a. in Indonesia, 6.5% p.a. in Korea, 4.2% p.a. in Malaysia and 5.2% p.a. in Thailand, on average during 1960-92. Agricultural growth has been particularly low in Sri Lanka, about 2.8% p.a. on average during 1961-93 compared to 3.5% and 4.4% in Indonesia and Thailand, respectively, during 1978-92. While Sri Lanka emphasized education and health like the more successful of its Asia neighbors, it was not able to exploit fully its human resource base to increase income as rapidly.4 9. Underlying Sri Lanka's lower growth rates lie other weaknesses in economic performance. First, while Sri Lanka invested on average about 20% of GDP during 1961-93, the more dynamic East- Asian countries in contrast invested some 32% of GDP during 1978-92. The latter were able to sustain this rapid accumulation process through high domestic savings rates, while in Sri Lanka the savings effort has been lower (only in 1993 did national savings surpass 20% of GDP). Furthermore, investment productivity in Sri Lanka has also been lower: on average, returns on capital during 1960-90 were about 21% compared to 26%-33% in Indonesia, Korea, Malaysia and Thailand.s Another contrasting indicator is Sri Lanka's long-run export performance, which despite recent improvements, has been poor (3.2% p.a. in constant prices between 1961-93). 10. These results largely reflect policy problems in a number of critical areas, compounded in the 1980's by ethnic and civil strife.6 Among the most important of these problems is weak macroeconomic management, in particular a chronic high fiscal deficit, resulting in inflation and crowding out of private investment. The cost of the war added to the budgetary imbalance. An overvalued exchange rate has been the other chronic macroeconomic policy problem, impeding the development of a competitive export sector and reducing growth. Second, the incentive and regulatory environments are also critical policy issues, and were especially constraining in the past. Investment regulations and prohibitions and foreign exchange restrictions stifled private investment, while high trade barriers protected inefficient activities and inhibited exports. The corollary of this is that the State's role is very wide in Sri Lanka. including areas where it has little comparative advantage, with negative effects on costs and efficiency, for example, in the State- 4 For a comparison of the initial conditions in Sri Lanka and East Asia, see S. Ahmed and P. Ranjan (1994). 5 S. Ahmed and P. Ranjan (1994). 6 The severity of extemal shocks is not a major factor explaining Sri Lanka's weaker growth performance. These shocks were about the same in Sri Lanka as those undergone by successful oil importers such as Korea and Thailand. see I.M.D. Little, R. Cooper, W.M. Corden and S. Rajapatirana (1994).  - 4 - owned plantations. Agricultural growth has also been affected by inappropriate land and price policies. Third, financial sector policies have hampered both efficient intermediation and resource mobilization.' 11. The Benefits of Peace. It is difficult to overstress the negative consequences of the civil war on Sri Lanka's economic performance. Most obvious are the terrible human suffering and loss of life and the destruction of large parts of the North and East, including social and economic infrastructure. The civil war has also severely reduced private confidence and investment. It has increased the budgetary defence burden by some 3 points to 4%-5% of GDP in the 1980's and 1990's, increasing public financing requirements. The war has also led to a loss of human capital through emigration. On the external side, tourism receipts have remained depressed, and only in 1994 did the number of tourists attain the levels reached in the early 1980's. With peace, as confidence is fully restored over the medium-term, private investment will increase, as will tourism. As the potential of the North and East is restored, and fully reintegrated into the national economy, peace will set the stage for an economic boom if the process is well managed. This includes tackling the macro-issues, as well as undertaking the structural reforms required to boost growth. Table 1: Adjustment and Growth in Sri Lanka Sri Lanka East Asiab' 1961-93 1971-77 1978-82 1983-89 1990-93 1978-92 Growth Indicators GDP p.c. (% change p.a.) 2.8 2.5 4.4 2.1 4.3 NA GDP (% change p.a.) 4.6 4.0 6.1 3.6 5.4 7.3 Agriculture (% change p.a.) 2.8 2.0 4.0 1.5 3.3 NA Industry (% change p.a.) 5.1 1.0 6.9 4.6 7.2 10.3 Services (% change p.a.) 4.9 5.2 7.4 4.2 5.5 7.9 Savings/Investment Indicators GDI (% of GDP) 20.0 16.2 27.5 23.9 23.6 31.6 GNS (% of GDP) 14.8a/ 12.9 14.7 15.7 17.5 NA GDS (% of GDP) 12.7 13.1 12.7 13.4 14.2 32.8 Extemnal Indicators Exports (% change p.a.) 3.2 -1.7 8.2 2.1 12.3 10.5 Imports (% change p.a.) 2.9 -2.4 15.7 -0.1 10.7 11.0 Current Account Balance (% of GDP) -7.2a' -3.3 -12.8 -8.2 -6.1 -0.3 Note: a/ 1970-93. b/ Defined as Hong Kong, Korea, Singapore, Thailand. and Taiwan, China. Source: The World Bank, International Economics Department. 12. Past Adiustment Efforts. In an attempt to boost growth, successive governments in Sri Lanka have implemented both macroeconomic adjustment measures and structural reforms. The reform effort started in 1978, when barriers to external trade were reduced and many of the most onerous controls on private sector activity were abolished. However, this first reform effort faltered in 1982 as the Government failed to reduce the fiscal and external deficits and the size and scope of the public sector, and more S. Ahmed and P. Ranjan (1994) provide evidence of the importance of these policy factors. Through an econometric time series model, they found that weak macroeconomic management (as measured by the black market foreign exchange premium), govemnment consumption (a proxy for the size and efficiency of the public sector) and the civil conflict are inversely related to real GDP growth.  - 5 - importantly, as ethnic and civil strife engulfed the country. Since 1989, when political violence declined, the implementation of the adjustment program intensified once again. 13. Economic reform has had three main elements in Sri Lanka. First, economic management was strengthened to build a stable macroeconomic environment favorable to private investment and savings. Second, efficient private sector activity was encouraged by dismantling price, investment and foreign exchange controls, lowering import barriers and privatizing state-owned enterprises. Finally, the Government decreased the amount of resources directed towards productive and commercial activities with the dual objective of reducing expenditures and providing more resources for the provision of public goods and services. The Government also implemented measures to increase cost effectiveness in those areas to remain in the public sector's domain. The adjustment effort was most successful in the second area. With regard to macroeconomic stability, between 1989 and 1993 there was also progress overall, although since the election year of 1994 budget discipline has deteriorated significantly. 14. The adjustment efforts have led to major improvements in Sri Lanka's economic performance (Table 1). During the two adjustment periods, 1978-82 and 1990-93, per-capita growth rates in Sri Lanka were almost double their long-run trend; the improvement is robust across all sectors. Other long-run growth indicators, such as investment/GDP and savings/GDP ratios, also strengthened considerably, auguring well for future growth and its sustainability.8 A most positive feature of the 1990-93 period is the rapid growth in private investment from 12% of GDP in 1987 to 18% in 1993. But perhaps most striking is the performance of the external sector. In contrast to their long-run trend, exports and imports increased by 12.3% and 10.7% p.a. on average during 1990-93. The export boom is mainly the result of rapid growth in the garment industry, although other non-traditional manufactured exports also are expanding quickly, but from a small base. The export orientation of the economy has grown rapidly to 34% of GDP in 1993 from 26% in 1988, as has the relative size of the manufacturing sector. These favorable results provide compelling evidence of the importance of policy factors in explaining Sri Lanka's weak performance in the past.9 15. The Government needs to persevere in the reform effort if these improvements in economic performance are to be sustained. Of particular importance, especially in view of the fiscal slippage in 1994, is ensuring macroeconomic stability. Better macroeconomic management needs to be complemented by policies promoting efficient private investment and savings, including providing the necessary economic infrastructure, and creating efficient and secure financial systems and flexible markets with few distortions. Despite all the progress achieved, the private sector reform agenda is still very large. The size of the reform agenda raises the question of what can be done to improve the implementation capacity of the public sector, while reducing its cost in view of the budgetary pressures. The remainder of this chapter reviews the main outstanding issues in these three areas, starting with macroeconomic performance. B. Improving Macroeconomic Management 16. Defining Macroeconomic Stability. Good macroeconomic management, considered critical for sustained growth (Box 2). is usually defined to mean that: Inflation is kept under control - in Sri Lanka this would require reducing inflation to single digits, close to that of its trading partners, in a sustainable manner. Sri Lanka's record on inflation since the early 1970's is not strong, despite frequent interventions by government to This is more true for the most recent adjustment period 1990-93. During the 1978-82 episode, the rapid expansion in economic activity was in part driven by the building of the low return large Mahaweli irrigation scheme, and the investment-domestic savings gap was un-sustainable. Improvements in the terms of trade are not a major factor in explaining the rise in the growth rate. In fact, the 1978- 82 episode coincided with the second oil shock, and during 1990-93, the terms of trade remained approximately constant.  - 6 - Box 2: The Benefits of Macroecononmc Stability International expenence suggests that macroeconomic stability is critical for growth for several reasons. First, responsible macroeconomic management reduces inflation and makes it more predictable, encouraging long-term planning, private investment and financial savings. Inflation is also potentially very hannful for the welfare of the poor since they have few financial reserves to draw upon if their incomes increase less than prices. Second, prudent public domestic borrowing leads to lower interest rates and does not crowd out private borrowing. hence favoring private investment. In addition, prudent macroeconomic policies strengthen private sector confidence, both domestic and foreign, once again favoring private investment. Macroeconomic stability also favors export growth by reducing inflation differentials with trading partners and facilitating extemal competitiveness. Finally, strong export performance coupled with cautious foreign borrowing will strengthen creditworthiness and ensure that external obligations can be met without sudden reductions in consumption and investment so hannfui to growth and economic welfare. The experience of East Asia proves that these benefits are not just theoretical. These countries have achieved lower inflation rates, higher savings and investment rates, more stable real interest rates, less appreciated and more stable real exchange rates, more favorable debt to export ratios, and of course, much higher per-capita growth rates than most other developing countries. There is also substantial empirical evidence that a stable macroeconomic environment, meaning low and stable inflation, small budget deficits and an undistorted foreign exchange market, is conducive to growth. The positive impact on growth has been found to work through two channels: good macroeconomic policies lead to higher investment as well as to greater productivity growth. For example, S. Fischer found that the 10% point increase in inflation would reduce the rate of growth of capital by almost one-half of a percentage point. Source: World Bank: The East-Asian Miracle (1993) and S. Fisher (1993). moderate increases in the prices of sensitive commodities. For example, not only was the average annual inflation rate (CPI) during the period 1980-91 relatively high, about 12%, it also fluctuated considerably during both the 1970's and 1980's. The comparison with the East-Asia countries is unfavorable which during the same period attained single-digit and stable inflation rates. Since August 1994, inflation has declined to single digits in Sri Lanka, but primarily by reducing administered prices, in some cases resulting in large subsidies (e.g., wheat). Public internal debt and external debt remain manageable - in Sri Lanka the main source of concern is the large overhang of public domestic debt (about 43% of GDP at end 1994) which has resulted in a large and rising interest burden for the budget (about 20% of current expenditures). While the stock of external debt is high (52% of GDP at end 1994), Sri Lanka benefits from concessional sources of financing. These obligations should not be a major cause for concern if external borrowing policies remain prudent and export performance satisfactory; and Policies are flexible, quickly responding to changing economic circumstances - in Sri Lanka, the little room to adjust public expenditures in the event of an unanticipated economic shock is of serious concern. The budget is dominated by interest payments, the wage bill and defense, all difficult to compress. 17. Large Budget Deficits and Overvalued Exchange Rates: Two Chronic Macroeconomic Issues. The key to achieving macroeconomic stability is prudent fiscal policy. High fiscal deficits increase aggregate demand resulting in inflationary pressures and higher external current account deficits. In addition, international evidence suggests that large fiscal deficits are probably the primary cause of macroeconomic instability in most countries. Excessive monetary financing leads to inflation, while excessive domestic borrowing drives up interest rates and crowds out private borrowing, and immoderate foreign borrowing leads to debt crises and loss of creditworthiness. Sri Lanka's record in this area is weak. For example, the average fiscal deficit during 1980-88 was high (14% of GDP), and contributed significantly to the rapid growth in domestic and international indebtedness, as well as to inflation. In  contrast, fiscal deficits during this period in the East Asia countries were significantly smaller, and their financing had small negative macroeconomic consequences. The progress achieved in Sri Lanka during 1989-93 in reducing the fiscal deficit from 11.2% of GDP to 8% was encouraging, but the slippages and new spending initiatives undertaken in 1994 associated witih the elections, have led to a sharp reversal to 9.7%. In 1995. the fiscal deficit is estimated to worsen somewhat at a ratio to GDP at 10.3% because of rising defence expenditures and slow progress in correctintg the 1994 slippages. 18. Another important element of good macroeconiomic policy, especially for a small, now outward looking economy like Sri Lanka, is mainltaininig a stable and competitive real exchange rate. International experience, including that of East Asia. demonstrates its importance for export promotion and sustaining trade liberalization. Maintainin,, a competitive real exchiange rate requires not only flexible exchange rate management that takes into account chaniges in the structure of protection, but also prudent fiscal and monetary policies. In Sri Lanka. the maniagement of the exchiange rate improved in 1980's with the unification of the exchange rate and the adoption of a managed float type mechanism. However. since the devaluation of 1978. the real exchange rate hlas shiowvn an appreciating trend, in part because of large government spendinig and capital inflowvs, especially official aid.'