World Bank Document

FILE COPY DOCUMENT OF INTERNATIONAL DEVELOPMENT ASSOCIATION Public Disclosure Authorized Not For Public Use Report No. P-1494-CE REPORT AND RECOMMENDATION Public Disclosure Authorized OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT Public Disclosure Authorized TO THE REPUBLIC OF SRI LANKA FOR A PROGRAM CREDIT Public Disclosure Authorized August 26, 1974 This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report. CURRENCY EQUIVALENTS (as of July 1, 1974) Parity Rate US$1 = Rs 6.47 Rs 1 = US$0.155 Rs 1 million US$155,000 FEEC Rate US$1 = Rs 10.68 Rs 1 US$0.094 Rs 1 million = US$94,000 The Sri Lanka Rupee, which had been linked to the U.S. Dollar from November 6, 1971, was re-linked to the Pound Sterling from July 10, 1972 onward at a parity rate of 4 1.00 = Rs 15.60. Parity,rates with all other currencies are determined from time to time by the Central Bank. The Central Bank of Ceylon makes foreign exchange available for certain categories of imports through purchase of Foreign Exchange Enti- tlement Certificates (FEECs) for which a premium is charged. The same premium is offered to exporters on foreign exchange earnings from the sale of non-traditional goods. The net revenue from the sale of FEECs is credited to the Government's Revenue Account. The premium is present- ly fixed at 65 percent of the Rupee parity rate and results in an exchange rate of Rs 10.68 = US$1. This rate currently applies to about 20 percent of merchandise exports, about 60 percent of merchandise imports and to most invisible transactions with the exception of aid receipts. FISCAL YEAR January 1 to December 31 L'TTLI?RNATIOWAL DEVELOPr E'.T ASS OCIATION REPORT A1ND RECOM§ZENDATIO,N OF TIIE PRESIDENT TO TI-E EXECUTIVE DIRECTORS Oi' A PROPOSED CREDIT TO THIE REPUBLIC OP eRI LAMIKA FOR A PROGRAM1 CREDIT 1. I submit the following report and recommendation on a proposed development credit to the Republic of Sri Lanka for the equivalent of US$15 million on standard IDA terms to help finance imports required for expansion of industrial and agricultural production and for improvement of selected services. PART I - THE ECONOMY 2. The latest economic report, "Recent Economic Developments and Prospects for Sri Lanka" (Report No. 407-CE of April 15, 1974), was dis- tributed to the Executive Directors on April 22, 1974. Country data are provided in Annex I. _ack3gound 3. The economic difficulties that have beset Sri Lanka since the late 1950's can be traced principally to two basic characteristics of the country's economic and social system: first, the specialization of production in three export crops - tea, rubber and coconut - which at the time of independence (1948) directly contributed nearly 40% of GNP and which has since declined to 13% in 1973; second, a political commitment to the welfare state which was made possible by the economic benefits derived from that export specialization. This commitment found its expression in two policy tenets which for the past quarter century all governments have fol- lowed in varying degrees: the supply of mass consumption goods, principally food and textiles, at low prices, and the provision of public services - mainly education, health and transport - free of charge or substantially below cost. 4. Sri Lanka's progress in social fields has been commendable. Health services are free except for a token contribution for out-patients visiting health centers and the health network is well developed. Educa- tion is provided free; however, the system is not geared to the country's needs. Sri Lanka has also tried to achieve a more equal distribution of income by enforcing policies aimed at the promotion of high wages, subsidi- zation of services, and the distribution of food below cost, or even free. The welfare state, however, was based on the prosperity of the external sector. Even if the terms of trade had remained in Sri Lanka's favor, it would have been increasingly difficult for the export sector to generate the foreign exchange resources and government revenues required to extend the benefits of the Government's social policy to a population which nearly doubled in 25 years. Unfortunately, Sri Lanka experienced a pronounced weakening in the market of two of its major exports, tea and rubber, beginning in the mid--fifties and, in addition, there was hardly any increase in the volume of exports between 1955 and 1970. As a result, there has been little growth in the economy over the last ten years. This stagnation has led to insufficient employment opportunities being created, so much so that in 1971, about 800,000 workers, or 18 percent: of the labor force, were un- employed. Even more striking is that nearly two-thirds of these had been educated beyond the ninth grade of schooling, a consequence of the extensive education facilities. It was very largely this situation that provoked the insurgency in April 1971 which posed a real threat to the stability of the country. 5. Economic policies to date have done little to offset the impact of the declining fortunes of the major export crops. Indeed, policies have been dedicated to maintaining welfare services despite the inadequacy of resources. A plethora of regulations and price controls has created serious disincentives as has been demonstrated by the failure over many years of domestic agriculture to replace imported products. However, the recent success in allowing market prices to stimulate production of a limited number of vege- table products provides an interesting contrast to the lack of performance under earlier policies. 6. It is against this background that Sri Lanka has now to face the twin shocks of sharply escalating costs for imported food, which are expected to absorb 60 percent of the country's export earnings in 1974, and a doubling of the oil import bill. Thus, Sri Lanka emerges as one of the LDCs most severely affected by the recent worldwide price inflation. 7. In these circumstances, the Government responded last fall by doubling the price of petroleum products, raising transport tariffs by 50 percent or more and making adjustments in the amount and price of food supplied at subsidized rates so that the cost of subsidies to be borne on the budget would be reduced. In the event, and as described later, the food subsidy adjustments have not proved adequate to offset the sharp increase in worldwide commodity prices. Nonetheless the members of the Aid Group meeting in Paris in May 1974 noted that the policies behind these measures constituted an important contribution towards improving the Gov- ernment's budgetary position. The members also recognized that immediate support was essential, and the Association urged that quick disbursing assistance should be provided. The purpose of this credit is to complement the Aid Group's efforts. Developments in 1973 and 1974 8. Agriculture. Agriculture accounts for 33 percent of the GDP and employs about 2 million people or 50 percent of the total labor force. Tea, rubber and coconuts are the principal crops, contributing 80 percent of the value of exports and 25 percent of total employment. Any substantial increase in foreign exchange earnings will have to come from exports of these products. There are no serious long-term demand constraints on the export of rubber or coconut products, although prices have proved to be quite vola- tile in reaction to short-term market conditions. For tea, prices have been depressed for many years on accourt of slow growth in demand and further expansion is expected to continue at only about 2 percent annually. Sri Lanka's tea production has been stagnant over the past decade, but with improved productivity Sri Lanka could increase export earnings by securing a share of this world expansion in demand. However, the production of these three crops has been adversely affected by Government policies; in particular, profit margins have been continually squeezed through tax and pricing policies with the result that investment, productivity and quality have declined. An Agriculture Sector Mission visited Sri Lanka during July to review the sector's prospects with the Government. 9. During 1973, export prices of rubber and coconuts rose sharply as part of the worldwide price escalation, although the price of the former is beginning to move down from the peak reached in March 1974; tea prices showed only a small gain. But, the costs of production also increased sharply, especially fertilizer. In addition, the FEEC system (the details of this system are explained in the frontispiece) prices many input requirements at a premium but does not offer the same benefit to export selling prices. Al- though there are various Government subsidy schemes for replanting and fertilizer, the net effect of the all round increase in prices has been only some limited improvement in the profitability of rubber. In the case of coconuts, production was depressed because of continued drought and disease, which led to the banning of exports for a period. In the case of tea, the combined effect of only a marginal increase in price and high costs of production led to yet further declines in profitability. 10. The Government has made attempts over the past few years to increase domestic production of food crops, especially rice. Paddy production reached a peak of 1.3 million tons in 1970, but has been sharply down since then largely on account of drought from 1971 to 1973.

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