Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Lf) C~~~~~~~~~~~~r ~~~ ~ r a W 0 R L D B A N K C OM PA RAT I VE MA C RO E C ON OM IC STUD IES Macroeconomic Policies,Crises, andGrowth in SriLanka, 1969-90 Macroeconomic Policies,Crises, andGrowth in SriLanka, 1969-90 P RE M A CHAND RA ATHUK O R A LA S I S I RA J AYA S U R I YA THE WORLD BANK, WASHINGTON,D.C. © 1994 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, N.W., Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing August 1994 The World Bank Comparative Macroeconomic Studies series emerges from a research project that reviewed the macroeconomic experiences of eighteen developing countries over a period roughly from 1965 to 1990. So that the studies might be published with relatively little delay, the books have been edited outside the World Bank's Office of the Publisher by the Macroeconomic Research Department. The findings, interpretations, and conclusions expressed in this publication are those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to the members of its Board of Executive Directors or the countries they represent. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Dr., Danvers, Massachusetts 01923, U.S.A. The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66, avenue d'1ena, 75116 Paris, France. Cover design by Sann Ferro. Premachandra Athukorala is a senior lecturer and Sisira Jayasuriya is a reader in economics in the Department of Economics at La Trobe University, Australia. Both were consultants to the World Bank for the writing of this book. Library of Congress Cataloging-in-Publication Data Athukorala, Premachandra. Macroeconomic policies, crises, and growth in Sri Lanka, 1969-90 / Premachandra Athukorala, Sisira Jayasuriya. p. cn. - (The World Bank comparative macroeconomic studies) Includes bibliographical references and index. ISBN 0-8213-2297-4 1. Sri Lanka-Economic policy. 2. Sri Lanka-Economic conditions. 1. Jayasuriya, S.K. 11.Title. 111.Series. HC424.A894 1994 339.5'0954893-dc20 94-31612 CIP Contents Foreword vii Acknowledgments ix Acronyms x Data Notes xi Chapter 1. Introduction I Chapter 2. Sri Lanka's Political and Policy History 4 The Arrival of Independence 6 The Political Economy of Consumer Subsidies 7 An Open-Market Economy: 1948-56 9 The Shift to Import Controls: 1956-65 10 Partial Liberalization: 1965-70 13 Regulation and Controls: 1970-77 17 The Turnaround in Economic Policy after 1977 20 The Rise of Ethnic Hostility 23 Chapter 3. A Profile of the Economy 25 Land and Resources 27 Growth and Welfare 28 The Structure of the Economy 29 Savings and Investment 31 Labor Force, Employment, Unionization, and Wage Formation 32 Trade Unions and Wage Formation 34 Commodity and Factor Markets 35 The Role of the State 46 Foreign Trade and Balance of Payments 51 Chapter 4. The First Crisis: 1973-75 56 Background to the Crisis 56 The Crisis 62 The Policy Response 65 The Pattern of Adjustment 71 vi Macroeconomic Policies, Crises, and Gro wthin Sri Lanka, 1969-90 ChapterS. The Second Crisis: 1978-82 76 The Background of the Crisis 76 The Investment Boom and the Terms of Trade Decline 79 Capital Flows, Income and Expenditure Effects, and Inflation 88 Chapter 6. Macroeconomic Policies and Long-Term Growth 94 Investment and Growth 94 Savings Behavior 96 Private Investment 98 The 1973-75 Crisis: Long-Term Effects 99 The 1978-82 Crisis: Long-Term Effects 103 Policy Responses, Income Distribution, and Political Stability 106 Chapter 7. Summary and Conclusions 112 Terms of Trade Fluctuations and Optimal Policy 112 Welfare Expenditures: Not the Key Issue 113 Macroeconomic Imbalances, and Trade and Exchange Rate Controls 114 Change and Continuity in the Post-1977 Period 115 Large Projects, Macroeconomic Stability, and Growth 115 Sri Lanka's Experience in a Comparative Setting 116 Conclusions 117 Appendix 1. 119 Determinants of Domestic Savings 121 Determinants of Private Investment 123 Short-Run Supply Response of Exports 124 Appendix II. Notes on the Statistics 129 Sources 129 National Accounts 130 Employment Data 130 Trade Data 131 Fiscal and Monetary Data 131 Wages 131 Price Data 132 Statistical Appendix Tables 134 Notes 158 Bibliography 161 Index 173 Foreword This volume is the product of a World Bank project on macroeconomic policy that reviewed the recent experience of eighteen countries as they attempted to maintain economic stability in the face of international price, interest rate, and demand shocks or domestic crises in the forms of investment booms and related budgetary problems. The project paid particular attention to the 1974-79 period (which in- cluded the first and second oil price shocks), the 1980-82 period of worldwide re- cession and external debt problems for many developing countries, and the 1983- 90 period of adjustment to economic difficulties and the resumption of growth. The objective of the project was to glean instructive lessons by analyzing the stabilization and adjustment policies pursued by these countries and assessing the outcomes. The authors of each country study were asked to deal with a common set of questions concerning the nature of the shocks or crises: their origin and de- gree of seriousness; the fiscal, monetary, exchange rate, and trade policies adopted in hopes of preventing permanent harm to the economy; and the results of the policies. No single computable macroeconomic model was used in the project, but the framework of the open-economy macroeconomic model was followed to ensure consistency in generalizing about results. This intensive study of many episodes generated ideas and suggested relationships showing the causes and effect behind policies, the nature of the shocks and crises, and the governmental response to them. The overall findings of the project are presented in a synthesis volume by I. M. D. Little, Richard N. Cooper, W. Max Corden, and Sarath Rajapatirana, Boom, Crisis, and Adjustment: The Macroeconomic Experience of Developing Countries. This study examines the macroeconomic policies of postindependence Sri Lanka, with emphasis on the management of shocks. In contrast to much of the literature on developing economies, which focuses on either long-term structural changes or short-term macroeconomic stabilization issues, this study links macro- economic policies to long-term growth. A major strength of the study is that eco- nomic policy changes are analyzed in the context of broader social and political circumstances. Some aspects of Sri Lanka's development policies have been unique among developing countries and have attracted worldwide attention. In particular, its remarkable achievements in advancing social welfare-achievements comparable vii viii Maeroeconomic Policies. Crises, and Growth in Sri Lanka, 1969-90 to those of many developed countries-have generated a large literature. Howev- er, there has been no comprehensive analysis of Sri Lanka's macroeconomic pol- icies and their implications for welfare and growth. This study fills this gap. The study offers an overview of the postindependence economic and political developments in Sri Lanka and a new perspective on the interaction between mac- roeconomic policies, political and social stability, and long-term growth. It chal- lenges widely held views on the relationship between welfare expenditures and growth. The study focuses on the policy experience of two periods (1973-75 and 1978-82), periods when the economy was subjected to major domestic and exter- nal stresses. Between these two periods there was a dramatic shift in government policies. A long period of extensive state intervention and inward orientation was followed by a commitment to economic liberalization. The analysis is of broader interest as a study of the reaction of a small open economy to major shocks under sharply contrasting policy regimes and external circumstances. Publication of this study was made possible in part by a generous grant from SIDA, the Swedish International Development Authority. Sarath Rajapatirana Director. "Macroeconomic Policies, Crisis, and Growth in the Long Run" Research Project Trade and Industry Policy Adviser Technical Department Latin America and the Caribbean Region Acknowledgments We accumulated many debts during the course of this research project, and we ac- knowledge some of them here. Our major debt is to Richard Cooper, Max Corden, Ian Little, and Sarath Rajapatirana, who provided guidance, advice, and support throughout the duration of the project. Max Corden and Sarath Rajapatirana de- serve special thanks for detailed comments and long discussions; they also extend- ed warm hospitality in Washington, D.C., as did Ian Little at Oxford. Vittorio Corbo and other participants at the Madrid and Mexico City workshops made many useful suggestions. Professor W. D. Lakshman generously shared his in- sights and made available valuable data and material, including unpublished manuscripts. Phil Sawicki gave much appreciated editorial assistance. Anita Bhatia insulated us from administrative and logistical problems, assisted by Mar- gert Kinzle and later by Charles Dade.