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Fears for the economy – and of the state

The Sri Lankan state’s debt dependent and public sector heavy economic strategy is crowding out private investment, lowering domestic savings and foreclosing a sustainable economy in the long term, business and economic analysts warned this week.

The Central Bank’s growth projection were this week revised downwards by ratings agencies RAM Ratings and Standard & Poor’s who also warned that Sri Lanka’s long term growth depended crucially on cutting government spending.

Meanwhile, fear is silencing critics of the government’s economic policies, one business leader protested this week.

The “government is trying to compete (against private citizens), it could be hotels, insurance and any other area,” the head of Laugfs, a gas distributing firm, told a business forum in Colombo, LBO Online reported.

Colombo’s increasing hostility to any criticism had silenced opposition to the government’s economic policies, Mr. W. Wegapitiya said.

“Very few are courageous enough to talk. It is a wrong signal” he said, adding that state economic policy was being “crafted by few individuals who were not aware of the agony the private sector has gone though.”

Risk to growth

The government recently took control back from global giant Shell of a previously privatized gas distributor, a move that was criticized as sending the wrong signal to foreign investors nervous about their assets being forcefully nationalized. Shell Gas Lanka has been renamed Litro.

While the Central Bank claimed that the economy was set to expand by 7.5 – 8.0% this year, RAM Ratings and Standard & Poor’s gave a more conservative forecast stating that they expected the economy to show growth of 6.5% and 6.2% respectively.

Both agencies warned that Colombo had to control government expenditure to bring down the debt burden and encourage private investment.

“The key risk is the fiscal risk, which remains because of Sri Lanka's high levels of debt and high levels of interest payments,” said Roopa Kudva, South Asia head for Standard & Poors' while speaking at a business forum in Colombo this week.

Similarly Dr. Yeah Kim Leng, RAM Ratings Chief Economist says that investor confidence would only improve if government borrowing started to fall.

“We are very concerned about the fiscal deficit but we expect it would be in order,” Dr. Leng was quoted by The Island newspaper as saying.

Investors wary

Despite the government’s public rhetoric, the government’s practices have failed to inspire investor confidence. Even after the end of the war, foreign direct investment into the island this year have fallen from last year - which was the most intense of the island's conflict.

Only $200 million FDI had come into the island in the first six months of 2010, suggesting that the total for this year will be less than the $690 million worth of foreign investment seen in 2009.

Notoriously inefficient, Sri Lanka’s public sector has not only crowded private investment it has also fuelled the expanding budget deficit that has led to high levels of debt.

Last year Sri Lanka’s total government debt stood at 86 % of GDP and debt repayments amounted to 42 % of government revenue.

In June 2009 Sri Lanka was forced to accept IMF assistance and has since started begrudgingly to control the budget deficit.

Investors and analysts are keenly awaiting the 2011 budget announcement, expected to be presented in Parliament on Monday to see how far the budget discipline will continue.

In order to boost investor confidence, the budget must contain cuts in government spending whilst also expanding government revenue by widening the tax base, analysts say.

Press reports have speculated that the budget will extend income tax and end the often ad hoc system of tax holidays usually extended to politically connected enterprises.

State's ethnic largess 

These changes are likely to be politically difficult, especially given the expectations of the state in the Sinhala-nationalist ideology exemplified by President Mahinda Rajapakse’s regime.

At present only 3% of the population of 20 million pay any form of income tax while cuts in government expenditure are likely to squeeze subsidies and public sector employment that are crucial to many household incomes.

Moreover, changes such as these, are an anathema to the majority Sinhala Buddhist community which expects the state to play the role of economic provider.

Under the Rajapakse administration, a long-standing Sri Lankan policy of discriminating in favour of the public sector to the detriment of the private sector has become particularly pronounced, the LBO Online analysis noted.

Whilst private sector banks are forced to list on the stock exchange, public banks remain exempt.

Public sector workers, including politicians, are exempt from income tax and public sector enterprises receive treasury handouts and have repeatedly had loans written off.

Public sector entities are also precluded from purchasing private sector insurance and are used to create a captive market for public sector insurance companies.

At the same time, public sector entities have cornered a number of markets. The Defense ministry runs a domestic commercial airline while the publicly owned State Fisheries Corporation is not only engaged in retail and distribution but has recently also secured control over fresh fish imports.

Sri Lanka’s road to sustainable economic recovery will require a massive reorientation of economic activity.

However, the policies that have since independence nurtured an almost exclusively Sinhala Buddhist public sector whilst punishing and restricting private enterprise have now become fiscally unsustainable.

Nonetheless, it remains to be seen whether Rajapakse regime will turn its back on Sinhala-nationalist ideology and push through the painful economic re-orientation that is now unavoidable if the country is to cope with the globalised world economy.