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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Sri Lanka calls for investments in import substitution

Sri Lanka calls for investments in import substitution

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Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics
June 04, 2012 (LBO) - Sri Lanka's finance ministry has called businesses to invest more in import substitution businesses, saying hundreds of millions of dollars are being spent to bring such goods from foreign countries. The finance ministry in its annual report said there was a "continued reliance" on importing food, pharmaceuticals, dairy products, textile, sugar and a range of construction material such as cement, steel, furniture and machinery.

"This requires investments in import replacement activities such as food crops, pharmaceuticals, dairy products, sugar, textile, plantation, apparels etc., to generate a strong economy," the finance ministry's annual report said.

In recent years Sri Lanka has fallen back to import substitution and becoming 'self-sufficient' as economic nationalism gripped the island.

High protectionist taxes are giving opportunities for some tax arbitraging producers running businesses which are not cost-efficient enough to compete internationally, to enrich themselves at the expense of stolen trade freedoms of the poorest sections of the population.

Import Substitution

The finance ministry said in 2011, 346 million US dollars had been spent on importing dairy products, 324 million dollars on medical and pharmaceutical products and 444 million US dollars on sugar.

"These key imports indicate a large market scope for investment in order to reduce foreign exchange outflows," the report said.

"The Board of Investment (BOI) in collaboration with relevant line ministries needs to focus on such investments for which specific project proposals and required domestic arrangements need to be firmed up to exploit potential areas of investment."

Treasury secretary P B Jayasundera said about 400 million dollars of cement was imported and rising construction was increasing the need for cement. Large firms including Tokyo Cement and Holcim was already in Sri Lanka.

"So we are asking, put your money," Jayasundera told reporters at a recent press briefing.

"The country is a middle income country, so another investment opportunity."

Jayasundera said nearly 400 million dollars a year of several types of commodities was big enough to justify investments to produce the goods domestically.

Sri Lanka however has price controls in cement which causes disruptions in supply from time to time.

He said with good planting material and practices agricultural products such as sugar can be produced. Sugar is produced in conjunction with alcohol and bio gas which increases their viability.

Bangladesh was producing pharmaceuticals and exporting them. Jayasundera said rather than espousing "free trade" the current administration was promoting other ideas such as 'food security'.

No protectionist taxes which can increase the costs for the sick and weak is being offered so far for drug businesses.

Trade Deficit

Jayasundera said Sri Lankans were now working abroad and remitting more than five billion dollars; tourists were coming and spending about a billion dollars, while ports and airports were also earning external service income.

"In other words we are earning more foreign service income than foreign service expenditure," Jayasundera told reporters at a recent media briefing.

"But we are disturbed about the rising level of trade deficit. The trade deficit is as big as the exports. It is not good."

However other analysts have pointed out that the trade deficit is a consequence of a surplus service account and net state borrowings, which is an 'export' of state debt.

Rather than spending money on foreign services and 'balancing' the service account, citizens who earn money from services spend them on merchandise imports, which in their own wisdom and exercising their freedom, they consider more valuable or useful.

Jayasundera said a depreciating exchange rate was one way to tackle the 'problem' of the trade deficit.

In the 2012 budget the President had imposed a depreciation of the currency peg and there had been debate whether the government should interfere in central bank business.

"Flexibility in the exchange is necessary but fundamental structural changes must also happen," Jayasundera said.

Savings Propensities

Classical economists however have pointed out for decades that trade deficits are a consequence of savings propensities rather than the exchange rate.

Even a country with a fixed exchange rate which exports capital either through the central bank (foreign reserve build up) or through private foreign investment via a free capital account or runs a deficit on services, can have a 'trade surplus' in the merchandise goods account.

Sri Lanka has had a chronic trade deficit ever since the opening of the economy in 1978 when people were allowed to go abroad to work, and became recipient of foreign investment and foreign aid, which is now being replaced by commercial borrowings.

Throughout that period the trade account has been in deficit and the exchange rate has been in chronic depreciation, destroying the real value of savings of all people, especially the small savers, helping keep people impoverished.

Imports reduce in Sri Lanka only in years following balance of payments pressure when domestic credit slows to allow a foreign reserve build-up or peoples' spending power is destroyed by currency depreciation.

There may also be lower net inflows to the government due to difficulties in rolling over debt.

Sri Lanka's exchange rate started to weaken after 1951 when a central bank with money printing powers with a so-called unstable 'soft-peg' was set up to join the failed Bretton Woods exchange rate system.

Under a 'hard peg' or currency board Sri Lanka's exchange rate had been stable from the previous century.

In March 2012 the exchange rate fell from 110 to 130 rupees as large amounts of credit taken by state enterprises to manipulate energy prices was compounded by money printed by the Central Bank to manipulate interest rates by 'sterilizing' foreign exchange sales.

The printed money expanded the trade deficit beyond the foreign exchange earned from exports of goods, services, net foreign borrowing, tourisms and foreign direct investment triggering a steady loss of foreign reserves.

The finance ministry also said Sri Lankan businesses should look at exporting to new countries and moving higher up the value chain. Exports which increase domestic income will also increase total imports, through not the trade gap.

Falling exports will also slow imports.

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