An Analysis Within a Poverty Focussed Computable

TRADE LIBERALISATION AND POVERTY IN A COMPUTABLE GENERAL EQUILIBRIUM (CGE) MODEL: THE SRI LANKAN CASE Submitted by R.M. Athula Kithsiri Bandara Naranpanawa B.Sc. (Agric.) Hons. (Sri Lanka) A thesis submitted in total fulfilment of the requirements for the degree of Doctor of Philosophy Department of Accounting, Finance and Economics Griffith Business School Griffith University Nathan campus, Nathan, Queensland 4122 AUSTRALIA June, 2005 DECLARATION I certify that the substance of this thesis has not previously been submitted for a degree or diploma in any university. To the best of my knowledge and belief, the thesis contains no material previously published or written by another person except where due reference is made in the thesis itself. ……………………………………….. R. M. A. K. B. Naranpanawa June 2005 ii DEDICATION This thesis is dedicated with affection to my mother, Kamala Naranpanawa and late father, K.M.S. Bandara Naranpanawa who toiled to educate and guide me in the right path. iii ACKNOWLEDGEMENTS This study would not have been possible without the invaluable assistance I received from various sources. I would like to acknowledge the financial assistance provided by the Griffith University during my PhD program. I would also like to acknowledge the partial financial assistance received from the Rubber Research Institute of Sri Lanka during my provisional PhD program. I am taking this opportunity to thank individually all those who have assisted me in one way or the other with my PhD program. Thanks must first go to my principal supervisor, Dr. Jay Bandara, for his invaluable guidance and inspiration throughout my PhD program at the Department of Accounting, Finance and Economics, Griffith University. His helpful comments made significant improvement to my thesis. I am thankful to my associate supervisor, Associate Professor Saroja Selvanathan, for her support and guidance during this research. I also appreciate her editorial guidance and thoughtful suggestions at the final stage of my thesis preparation. I would like to thank Professor Tom Nguyen and Professor Christine Smith for their strong support during my PhD candidature. I give my special thanks to Dr.Suri Rajapakse, Associate Professor Saroja Selvanathan, Professor Anthony Selvanathan, Associate Professor Athol Fitzgibbons, Dr Patti Cybinski, Dr. John Forster and Dr. Jay Bandara for helping me ease the financial burden during my PhD program by providing me with the opportunity to work as a tutor. I also extend my thanks to administrative and secretarial staff of the Department of Accounting Finance and Economics, particularly Ms Debra Bell and Ms Gayani Bandara for their assistance during my PhD program. I thank Ms Jennifer Beale for her valuable editorial input. I would like to thank Mr Gregg Watts and members of the Economic Analysis Team of Queensland Treasury for their warm support and understanding during the final stage of my PhD. iv Also, I wish to acknowledge sincerely the support and inspiration I received from my mother, my brother, Asela Naranpanawa and my wife’s parents, Duleep and Eunice Gooneratne, during my PhD program. Last, but not least, I warmly thank my wife Niromi for her patience and willingness to go through my PhD candidature with me. Also, I fondly thank my son, Rajitha, and my daughter, Sachini, for their love that has made this hard work bearable. v Abstract Many trade and development economists, policy makers and policy analysts around the world believe that globalisation promotes growth and reduces poverty. There exists a large body of theoretical and empirical literature on how trade liberalisation helps to promote growth and reduce poverty. However, critics of globalisation argue that, in developing countries, integration into the world economy makes the poor poorer and the rich richer. The most common criticism of globalisation is that it increases poverty and inequality. Much of the research related to the link between openness, growth and poverty has been based on cross-country regressions. Dollar and Kraay (2000; 2001), using regression analysis, argue that growth is pro poor. Moreover, their study suggests that growth does not affect distribution and poor as well as rich could benefit from it. Later, they demonstrate that openness to international trade stimulates rapid growth, thus linking trade liberalisation with improvements in wellbeing of the poor. Several other cross-country studies demonstrate a positive relationship between trade openness and economic growth (see for example Dollar, 1992; Sach and Warner, 1995 and Edward, 1998). In contrast, Rodriguez and Rodrik (2001) question the measurements related to trade openness in economic models, and suggest that generalisations cannot be made regarding the relationship between trade openness and growth. Several other studies also criticise the pro poor growth argument based upon the claim of weak econometrics and place more focus on the distributional aspect (see, for example, Rodrik, 2000). Ultimately, openness and growth have therefore become an empirical matter, and so has the relationship between trade and poverty. These weaknesses of cross-country studies have led to a need to provide evidence from case studies. Systematic case studies related to individual countries will at least complement cross- country studies such as that of Dollar and Kraay. As Chen and Ravallion (2004, p.30) argue, “aggregate inequality or poverty may not change with trade reform even though there are gainers and losers at all levels of living”. They further argue that policy analysis which simply averages across diversities may miss important matters that are critical to the policy debate. In this study, Sri Lanka is used as a case study and a computable general equilibrium (CGE) approach is adopted as an analytical framework. Sri Lanka was selected as an interesting case in point to investigate this linkage for the following reasons: although Sri Lanka was the first country in the South Asian region to liberalise its trade substantially in the late seventies, it still experiences an incidence of poverty of a sizeable proportion that cannot be totally attributed to the long-standing civil conflict. Moreover, trade poverty linkage within the Sri Lankan context vi has hardly received any attention, while multi-sectoral general equilibrium poverty analysis within the Social Accounting Matrix (SAM) based CGE model has never been attempted. In order to examine the link between globalisation and poverty, a poverty focussed CGE model for the Sri Lankan economy has been developed in this study. As a requirement for the development of such a model, a SAM of the Sri Lankan economy for the year 1995 has been constructed. Moreover, in order to estimate the intra group income distribution in addition to the inter group income distribution, income distribution functional forms for different household groups have been empirically estimated and linked to the CGE model in “top down” mode: this will compute a wide range of household level poverty and inequality measurements. This is a significant departure from the traditional representative agent hypothesis used to specifying household income distributions. Furthermore, as the general equilibrium framework permits endogenised prices, an attempt was made to endogenise the change in money metric poverty line within the CGE model. Finally, a set of simulation experiments was conducted to identify the impacts of trade liberalisation in manufacturing and agricultural industries on absolute and relative poverty at household level. The results show that, in the short run, trade liberalisation of manufacturing industries increases economic growth and reduces absolute poverty in low-income household groups. However, it is observed that the potential benefits accruing to the rural low-income group are relatively low compared to other two low-income groups. Reduction in the flow of government transfers to households following the loss of tariff revenue may be blamed for this trend. In contrast, long run results indicate that trade liberalisation reduces absolute poverty in substantial proportion in all groups. It further reveals that, in the long run, liberalisation of the manufacturing industries is more pro poor than that of the agricultural industries. Overall simulation results suggest that trade reforms may widen the income gap between the rich and the poor, thus promoting relative poverty. This may warrant active interventions with respect to poverty alleviation activities following trade policy reforms. vii TABLE OF CONTENTS DECLARATION ii DEDICATION iii ACKNOWLEDGEMENTS iv ABSTRACT vi TABLE OF CONTENTS viii LIST OF BOXES xiii LIST OF FIGURES xiv LIST OF TABLES xvi LIST OF ABBREVIATIONS xviii CHAPTER 1: INTRODUCTION 1.1 INTRODUCTION 1 1.2 TRADE LIBERALISATION AND POVERTY IN SRI LANKA 5 1.3 OBJECTIVES OF THE RESEARCH 8 1.4 OUTLINE OF THE THESIS 10 1.5 CONCLUDING REMARKS AND MAJOR FINDINGS 10 CHAPTER 2: TRADE LIBERALISATION AND POVERTY: THE SRI LANKAN EXPERIENCE 2.1 INTRODUCTION 12 2.2 SRI LANKA AS A CASE STUDY 13 2.2.1 Sri Lanka’s Trade Liberalisation Experience 15 2.2.2 Achievements of the economic liberalisation process 23 2.2.3 Trends in Income Distribution and Poverty of Sri Lanka 29 2.3 CONCLUDING REMARKS 36 CHAPTER 3: LITERATURE SURVEY ON POVERTYFOCUSSED CGE APPLICATIONS IN DEVELOPING COUNTRIES 3.1 INTRODUCTION 37 3.2 THEORETICAL AND EMPIRICAL APPROACHES IN ANALYSING TRADE AND POVERTY LINKAGE 39 viii 3.3 WHY POVERTY FOCUSSED CGE MODELS ARE IMPORTANT 46 3.4 APPLICATIONS

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