Yet the Sinhala political elite soon pandered to the worst instincts of the Sinhala ethnic majority, egged on by a xenophobic Buddhist clergy. Successive governments played the populist ethnic card, increasing discrimination against the Tamil minority. This sowed the seeds of the Tiger terrorist movement, culminating in all-out violent conflict in 1983.
Disastrous economic policies exacerbated the civil unrest. Sri Lanka suffered from chronic fiscal and monetary profligacy, and followed the Indian path of rampant government intervention and trade protectionism. By the mid-1970s, the economy was close to ruin. Economic growth had almost come to a halt — it averaged less than three per cent between 1970 and 1976 — real incomes were stagnant and unemployment reached 25 per cent of the labor force. Welfare policies churned out educated youth among the poor, but they had no job prospects in a stagnant economy. Disaffection led many to extremism and violence, not just in the Tamil north but also in the Sinhala south.
The one bright spot was the major liberalization of the economy in the late 1970s, followed by reform bursts in later decades. Sri Lanka’s reforms re-opened the country’s economy to the world and created thriving domestic industries. Thus despite civil war, macroeconomic instability and misgovernance, Sri Lanka has grown at about six percent annually. Average real incomes, at about $1,500, are 50 per cent higher than they are in India. Outside the fighting zones, ordinary people are significantly better off than they were a generation ago.
Key to this success has been industrialization and a more diversified services economy. Employment in the formal manufacturing sector has more than doubled since 1980; and the share of manufacturing in total merchandise trade has increased from five per cent to close to 70 per cent of GDP. The star in the firmament is a strong, labor-intensive garments industry — a direct product of liberalization. This industry, which emerged in the early 1980s, now accounts for about 50 per cent of total export earnings and employs about one
million people.
Still, Sri Lanka is a sad tale of what might have been. Reform has proceeded in stop-go fashion. Public spending, budget deficits and inflation have run wild. Of a country of 20 million people and a labor force of under seven million, around one million now work for the bloated public sector.
Inflation peaked at close to 30 per cent last year, and official reserves were blown away defending an exchange-rate peg of 108 rupees to the dollar. Yet again, Sri Lanka faces a home-brewed balance-of-payments crisis and is currently negotiating a $1.9 billion loan with the International Monetary Fund. Trade protectionism has increased, with a paraphernalia of additional import taxes. Discretionary powers have also been used more frequently and selectively to restrict imports, for example through customs delays and extra charges. The domestic private sector has been repressed with additional taxes and regulatory burdens. The government has even set up its own – predictably loss-making – low-cost airline.
Now, academics and intellectuals advising the government are advocating a state-directed economy, infant-industry promotion and agricultural self-sufficiency. Policy making is more populist and unpredictable, favoring the politically connected and sidelining technocratic advice. Corruption and institutional rot set in long ago, but recently they have plumbed new depths.
A widely shared sentiment in Sri Lanka is that military victory will translate into peace and fast development. This is wishful thinking. Without a policy overhaul, Sri Lanka faces either slow material decline or something worse, especially with a bleak global economic outlook. The short-term imperative is to allow the exchange rate to devalue to a market-determined level, cut public subsidies and make fiscal and monetary policy more transparent.
Beyond that, trade tariff hikes should be reversed, with accompanying simplification of trade and foreign-investment measures. There needs to be deep public-sector reform; a move to market pricing for oil and electricity; and, not least, big cuts in the defense budget. Drastic domestic deregulation is also imperative to cut the high cost of doing business. In the longer-term, Sri Lanka needs to revamp its rotten political culture and public institutions.
With peace and East Asian-style policies of macroeconomic prudence, openness to the world economy and better government at home, Sri Lanka would be where Malaysia is today. On that measure, absolute poverty would have been eradicated, average living standards would be four times what they are now, clusters of multinational enterprises would link the economy to global supply chains, tourism would be flourishing, services would be hitched to the Indian outsourcing juggernaut, and ordinary Sri Lankans would be able to realize aspirations they can only dream about today.
Given the government’s record, the odds are against a near-term economic policy turnaround. A weak, divided political opposition does not provide a credible alternative. It is safe to say that without a change of economic direction, Sri Lanka will continue to fail to achieve its golden potential – with or without peace.
Mr. Sally is director of the European Centre for International Political Economy and professor of international political economy at the London School of Economics. This article was originally published in the Wall Street Journal Asia and may be found here.