What Make Higher Growth Sustained?

Sri Lanka was able to record around 5-6 annual average economic growth rate during the 30 years prior to the end of the North and East war. Many viewed the protracted civil war as the one of the key barriers to the socio-economic development in the country. Hence, it is assumed that the end of the war may lead to rapid and steady economic growth and development and everyone in the society looked for a bright future ahead. Igniting these expectations, during the first two years, several macroeconomic indicators recorded impressive performance. For instance, Gross Domestic Products (GDP) grew at a rate of 8 per cent during 2010-2011. Unemployment and inflation recorded a relatively low rate while foreign direct investment (FDI) inflows, export earnings, foreign reserves, and tourist arrivals were at satisfactory levels. Similarly, during the early years of the post-war period, private sector showed some dynamism mainly in terms of higher consumption. All these developments contributed to raise the high hopes which everyone – politicians, intellectuals, policy makers and the general public – had about the Sri Lanka’s future. Partly due to those favorable developments, the government announced that it intends to double the per capita income within a six year period and to achieve the status of “The Emerging Wonder of Asia”.

Ruling party politicians and some officials are of the view that Sri Lanka could sustained her growth rate at 7-8 per cent during the long run since government has embarked in several large scale investment projects and maintain stable and prudent macroeconomic policies thereby attracting local and foreign investors. They often highlight various macroeconomic and other socio-economic indicators to show that the economy is healthy and Sri Lanka could achieve high-income status by avoiding the middle-income trap.

However, independent observers see the opposite of the above picture. Many are of the view that economic fundamentals that sustain higher growth have not improved thereby raising concerns to what extent present higher growth is sustainable. In order to analyze this dilemma, it is important to distinguish the difference between level effect and rate effect with respect to economic growth. The level effect refers to any change in GDP due to changes in amount of inputs employed while the rate effect refers to change in economic growth rate due to change in output per unit of input (productivity). Higher growth rate could be sustained in the long run only if the rate effect is improved permanently i.e. through productivity enhancement in the economy permanently. In Sri Lanka, according to independent observers, the post-war higher growth is mainly due to three main factors; (a) tapping un-utilized and under-utilized productive resources in the war-affected areas, (b) debt-driven public sector infrastructure programmes, and (c) greater monetization of the economy (Many economic activities that were either marginally in being there in the market or completely absent in the market previously have significantly monetized in recent years. One of the reasons for higher growth rate in many developing countries is this monetizing process). Some even add to this list the effect of over-costing of mega infrastructure projects. Hence, what you see in the economy right is largely the level effect; i. e. the short-run Keynesian multiplier effect. This would disappear gradually when the additional amount resources (mainly infrastructure programmes) injected into the growth process comes to an end. Government cannot continue forever with infrastructure development projects either the requirements may end or it may find financial difficulties. At the end of the day the economy will witness gradual slowdown in economic growth rate unless there is concerted effort to improve business climate by improving economic and political institutions as discuss below. Hence it is important to keep it in mind that an increase in GDP due to growth of inputs is not sustainable since any economy cannot expand its input base continuously in the long-run.

Economic growth literature, both theory and empirics, has identified several factors that determine the rate effect. Accordingly, productivity improvement through technological enhancement, greater domestic and foreign private investor participation in the economy and innovation is imperative to sustain high economic growth in the long-run. Leading economists are of the view that quality of economic and political institutions is one of the key parameters that determine domestic & foreign investment levels, technological improvement and innovation in an economy. Inclusive political and economic institutions provide the basis for sustaining higher growth rate in an economy. Inclusive economic and political institutions provide pro-growth incentives for economic agents to engage in economic activities that enhance technological improvements, domestic and foreign investment and innovation. Hence it is important to examine to what happened to the economic and political institutions in the post-war period in order to understand the sustainability of the present higher economic growth.

In recent years, Sri Lanka has witnessed a rapid and continuous deterioration of the quality of political and economic institutions thereby becoming those institutions more extractive in nature. Extractive institutions, as against inclusive ones, cater to the interest of few in the society thereby discouraging genuine local and foreign private investors to invest in vital areas to improve productivity in the economy.

Figure reports one of the several indices developed by many organizations and individuals to monitor the quality of political and economic institutions in an economy. It shows that during the last decade, quality of key political and economic institutions has deteriorated rapidly and continuously. The figure shows that compared to 2003, quality of political institutions gradually deteriorated in later years. Among the sub-indices, rule of law deteriorated sharply. More specifically, figure shows that rule of law and democratic institutions in the country have severely hampered. As the Sri Lanka Governance Report 2012/13, published by Transparency International, says there a number of incidents in recent years that show rule of law in the country is greatly threatened and especially, people attach to the ruling party played a mock with the law in the country. The reports further says that the government took several steps such as introducing 18^th amendment to the constitution, curtailing media freedom, suppressing pubic protest, intervening into judiciary to tighten its hold onto the political power thereby moving towards authoritarian regime. According to the report, check and balances in the executive and legislative power were removed and political henchmen were appointed into key positions in the administrative and judicial system. Further, explicitly or implicitly people in power encourage extremists groups to raise their ugly head. These actions certainly have bad repercussions on investment climate no matter the financial concessions given and modern infrastructure developed to attract local and foreign investment. It is important to recognize that financial concessions alone cannot attract local and foreign investment and encourage economic agents to engage in productivity enhancement activities.

When looking through the lens of new institutional economics and the existing growth literature it is quite clear that higher growth witnessed by the economy in the post-war period may become temporary if government does not take actions to improve the quality of economic and political institutions. It is important to uphold the rule of law in the country and to enhance the democratic institutions since incentives provided by existing institutions discourage both local and foreign investors no matter the financial concessions given and the state of the arts infrastructure developed in the country. Infrastructure development is essential for economic growth; however, growth will not be sustained unless economic agents productively use them in the long-run. Infrastructures developed in recent years may remain idle unless the country attract domestic and foreign investors to start business. Hence need of the hour is to halt the deterioration of the quality of economic and political institutions. Policy makers must pay greater attention to arrest this deteriorating situation thereby avoiding any slowdown in the economic growth or risking the growth potentials opened by with the end of the war.