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MBA Night 2012 - University of Peradeniya Keynote Address: “Avoiding Middle Income Trap and Role of Private Sector”
Keynote address by ADB Sri Lanka Resident Mission Country Director Rita O'Sullivan on 18 August 2012 at Earl's Regency Hotel in Kandy, Sri Lanka
Ladies and Gentlemen:
I am very pleased to be here today at the MBA Night organized by the MBA Association, University of Peradeniya, and have this opportunity to give my key note address to distinguished guests, business leaders and MBA students.
Now it is the time for Sri Lanka when private businesses are becoming ever more vital for further development of this country. Sri Lanka is at an important milestone, having reached middle income status recently. This new status brings with it new opportunities and new challenges. Sri Lanka’s continued economic progress has to be considered within the context of the great changes that are taking place globally, and most importantly in Asia. Asia's path to prosperity will be led by fast growing economies such as the People's Republic of China, India, Indonesia and Viet Nam. The entry of these Asian economies to the group of middle-income economies will have significant implications on the region's growth structure, with declining dependence on the region's traditional export markets, and with domestic demand emerging as a major source of growth.
The current century is widely seen as Asia’s century and if Asia continues to follow its recent trajectory, by 2050 its per capita income could rise six fold in purchasing power parity (PPP) terms to reach Europe’s levels today. It would make some 3 billion additional Asians affluent by current standards. By nearly doubling its share of global gross domestic product (GDP) to 52 percent by 2050, Asia would regain the dominant economic position it held some 300 years ago, before the industrial revolution.
However, Asian economies must be wary of falling into the "Middle Income Trap" if the region's growth trajectory is to be sustained.
Middle-income trap (MIT)
Middle-income trap describes the phenomenon where an economy reaches middle-income levels on a per capita basis, and is unable to transition to high-income. The transition from low- to middle-income leaves an economy dependent upon low value-added activities, like labor-based manufacturing. These activities expand as the underemployed rural population moves to urban areas as low-cost labor. Once the majority of the rural population has been employed and production continues to increase, wages begin to increase. The economy begins to lose its comparative advantage to lesser developed areas that can offer cheaper labor. Ideally, economies replace this loss by gaining a new competitive advantage in higher value-added activities. The focus shifts to capital- and skill-intensive activities, and the service sector flourishes. In order to catch up with competitors, these economies must make advancements in human capital and technology. Economies become trapped when they are unable to find a new competitive advantage in a higher value-added activity.
In order to avoid the middle income trap, as wages rise and cost competitiveness declines, country’s growth strategies need to introduce new processes and find new markets to maintain export growth. Domestic demand is also important in sustaining growth as an expanding middle class begins to use its increasing purchasing power to buy high-quality, innovative products. The biggest challenge is moving from resource-driven growth that is dependent on cheap labor to growth based on high productivity and innovation. Policies should focus on helping middle-income economies move from catch-up to frontier status in technology by strengthening human capital development and building an environment conducive to innovation and entrepreneurship. An important requirement here is building a high-quality education system which encourages creativity and supports breakthroughs in science and technology. Avoiding the Middle Income Trap also requires more responsive and modern institutions to support competition and innovation. Such institutional development is often a long-term endeavor that presents a challenge for policy makers since the benefits are not immediately visible and may be difficult to attribute directly to specific policies. Therefore, political leadership is essential in averting the Middle Income Trap and sustaining the goal of sound, long-term growth even after the material well-being of a select few has been secured.
Findings on MIT in various studies
Various studies have attempted to analyze countries that have successfully reached high income to provide generalized strategies for averting the middle-income trap. The World Bank1 suggests that governments should be proactive in anticipating and planning for the middle income transition. For example, the government of Republic of Korea anticipated this shift in its economy in the 1980s and 90s. It promoted foreign direct investment, joined the Organization for Economic Cooperation and Development (OECD) and privatized industries. The government also refrained from intervening as labor-intensive manufacturing moved to other regions. In order for an economy to experience a successful middle-income transition, the government must be willing to do away with some policies that worked for the first stage of growth. Keeping outmoded policies in place will stunt the economy’s natural restructuring.
The chief economist at the Asian Development Bank identifies four similarities among countries that have fallen into the middle-income trap. He suggests they exhibit low investment ratios, slow manufacturing growth, limited industrial diversification and poor labor market conditions. His analysis of Indonesia suggests that governments must focus on a structural transformation in order to avert the trap. In order to reduce income inequality between a nation’s rural and urban areas, governments should create more jobs in manufacturing. He also calls for investment in both “hard” and “soft” infrastructure to prepare the economy for the advanced stage of development.
The crux of Japan and East Asia‘s success was that their development followed closely their comparative advantage and that their governments played a facilitating role. Just before the Second World War, textiles and other light industrial goods accounted for 60-75 percent of all Japanese exports. Japan‘s textile industry was at its peak before the Second World War. In the 1960s-1970s, Japan supported its heavy manufacturing sectors, including machinery and automobiles. In the 1980s-1990s Japan acquired shares in the home appliances, electronics and computer markets. The World Bank’s (1993) study on the “East Asian Miracle” documents in detail the Japanese government's policy of importing technology for the development of key industries, and the provision of institutional arrangements between the government, banks and businesses. In addition, the government created contests that combined competition with the benefits of cooperation among firms and banks, so individual firms endeavored to choose, adapt, and then perfect imported technologies, and introduced the world renowned “just-in-time” automobile assembly lines2.
Republic of Korea‘s process of industrial upgrading reflected the country‘s shifting factor endowment structure: The success of labor-intensive industries led to capital accumulation and an increase in the capital intensity of industries. Like Japan, learning and capacity building played a very significant role in Korea‘s growth process. Notably, when Republic of Korea decided to promote ship-building it imported large numbers of foreign workers who had relevant skills and were able to pass on those skills to the indigenous population, thus creating the type of vocational training necessary for the future growth of the industry.
Indonesia, Thailand and Malaysia have recently presented transformation plans aiming to bring them to a high-income level. A successful outcome of these projects depends on the one hand upon recruitment to the educational sector, particularly vocational and tertiary education, and, on the other hand, upon the reshaping of skills and upgrading initiatives.
Role of private sector
A key mechanism for economic growth is higher productivity and knowledge transfer, and the private sector is the critical driver of this process.As economies move into higher income levels, the role of the private sector expands. In fact, in high income nations, economic activity is led by the private sector in a competitive environment. Competition will contribute to efficient allocation of resources and creation of vibrancy and dynamism in economic activity. At the same time, a strong institutional framework needs to be in place to avoid market failure and to ensure a competitive and supportive business environment. Private sector also needs to transform itself through research and development and innovation to meet the challenges of the country’s new context and avoid stagnation.
The role for private sector in avoiding the middle income trap has many aspects. As the driver of growth in middle income economies, the private sector needs to focus on innovation and higher productivity. Once a country reaches middle income levels the private sector has to be responsive to the new challenges facing the country and position itself to exploit new opportunities. Investment in research and development needs to be scaled up and human resources and technology need to be upgraded to enable firms to move into more sophisticated production.
In identifying the skills that would enable economies to move into higher levels of income and development, the private sector represents the demand side of the skills equation. Governments need to coordinate closely with the private sector in identifying the skills and research needs of the economy. Firms need to further invest in human capital development to better equip their employees with continuous advancement in knowledge and skills. The private sector needs to be the driver in developing these skills and in research and development. In both Malaysia and Singapore industrial development and the transformation towards a knowledge economy have been facilitated by strong state planning institution. The transformation process has included broadening private sector participation in previously state led activities. State planning has even pushed privatization of Higher Education Institutes forward and facilitated partnership agreements. Private corporations in medical, bio-tech, IT and other industries globally have taken over most of Research and Development, thus capturing the knowledge base of labor from public to private controlled knowledge.
Case of Sri Lanka
Sri Lanka has reached middle income status and needs to focus on avoiding the middle income trap, and reorient the policy framework to move towards higher income levels. Currently Sri Lanka’s industrial base is highly concentrated and comprises of high labor intensive, low technology based products. Sri Lanka’s exports markets are also concentrated in Europe and the USA. Sri Lanka’s spending on Research and Development (R&D) remains low, and much remains to be done in creating an enabling environment to support private sector development to the level required for a middle income economy
Sri Lanka has identified the infrastructure dearth faced by the country and is making notable progress in improving and expanding the country’s infrastructure. The government has also realized the importance of skills development and recognized the significant skills gap that prevails between the demands of a middle income economy and the skills produced by the system presently. More effort needs to be put in to partner with the private sector, both in moving towards a sophisticated products and services base and in increasing investments in infrastructure. This partnership would range from coordinating with the private sector in identifying its needs and improving the business climate and creating an environment suitable for innovation as well as developing a clear policy framework to facilitate public private partnerships.
The Development Policy framework of the Government for the six year 2010 -2016 aims to increase GDP growth to above 8% in the medium term and double per capita income from the current level of $2400 to $4200. The Government has embarked upon an ambitious plan to remove infrastructure bottlenecks in the country and to reduce the infrastructure gap between Sri Lanka and the other countries in the region.
To increase and sustain growth at above 8%, investments have to be increased up to 33-35%. Increase in investments by the domestic private sector and inflow of FDI is key to achieve the expected higher rate of investment. However, despite the improved political and economic environment, the growth in private investments, both domestic and foreign falls below the expected levels.
The Government has nevertheless undertaken significant amount of investments across a number of sectors ranging from transport, energy, water, sanitation and irrigation on its own. The existing Port and Aviation infrastructure is inadequate to accommodate the increased passenger and freight transportation. In order to expand capacity several large scale investments have already commenced such as the development of the Colombo South Port, Hambantota International Port and the second international airport at Mattala.
In the higher education sector which suffers from poor capacity, quality and relevance, the legislative amendments need to be implemented enabling greater private sector participation. The government’s Education Sector Development Framework and Program aims to increase equitable access to basic and secondary education, improve the quality of education, and strengthen service delivery. The government emphasizes training of teachers to use modern methodologies and to accelerate skills creation. Curriculums are also being suitably revised, especially at the secondary level. The government is focusing on skills development and aims to double the number of students entering local universities by 2020.
Lack of an institutional framework that enables and facilitates implementation of projects is an impediment to private sector participation. The Government not having a pipeline of viable and bankable projects further discourages private sector investments. In addition to these the under-developed financial sector works as a constraint in securing long term domestic funding for private sector infrastructure projects. Resistance to private sector participation arising from poor stakeholder consultation and awareness creation of the general public of the benefits of private sector participation in the provision of infrastructure also act as a constraint.
ADB’s interventions in Sri Lanka
ADB thrust on private sector development is recent focuses mainly on three areas; i) creating an enabling environment for business, ii) generating business opportunities in ADB financed public sector projects and iii) to catalyze private investments through direct financing, credit enhancements, and risk mitigation instruments. These thrust areas of ADB cover four priority areas at operational level: a) governance in the public and private sectors; b) financial intermediation; c) public-private partnerships; and d) regional and sub regional cooperation.
Among ADB’s past assistance to develop the private sector in Sri Lanka some examples are worth noting here. ADB in Sri Lanka had been successful in commercializing Lanka Electricity Company (LECO), a government owned entity engaged in power generation. ADB took initiatives to reform two commercial state-owned banks, Bank of Ceylon (BOC) and People’s Bank (PB) through professional management, introduction of best practices in governance, reduction of the number and volume of NPLs, reducing exposure to SOEs, and introducing credit and treasury risk management. Further new computer systems to integrate the extensive branch networks of each of the banks were introduced and to improve efficiency. These initiatives lead to the improvement of profitability of both banks. ADB assisted in creating public private partnerships in power generation by assisting private sector thermal power generation in Sri Lanka. At that time it assisted in overcoming the power shortages. ADB’s policy dialogue with the Government led to government to the adoption of a PPP approach for the Colombo Port Expansion Project. Major reforms in the history of TVET sector were launched by the Skill Development Project established with the assistance of the Asian Development Bank by the Ministry of Vocational and Technical Training from 1998 to 2006. This project had a project component to promote participation of private sector and NGO sector in promotion of vocational training and skill development.
Under the last Country Partnership Strategy (CPS) of ADB for Sri Lanka (CPS 2009-2011) the focus was significantly on large scale infrastructure in transport, energy, and water supply. The current CPS 2012-2016, which was approved last year, adjusted our strategy to address the middle income agenda. While supporting the same areas of infrastructure, the current CPS assigns a critical role to the private sector, and skills development has been assigned high priority. In fact, the CPS 2012–2016 identified these as pillars. The second pillar of CPS is catalyzing private investment and enhancing the effectiveness of public investment, and the third pillar is human resource and knowledge development.
Under the second pillar, to increase the effectiveness of public investment and catalyzing private investments, ADB will assist by institutionalizing PPPs through early and sustained engagement in (i) developing a suitable enabling environment for PPPs; (ii) early identification of PPP candidate projects, concept development, and pre-feasibility assessment; and (iii) project structuring by assessing commercial, technical, environmental, and financial viability. ADB will help the government strengthen the policy, legal, and regulatory framework for fostering PPPs, including improving the institutional framework. Constraints in the financial sector limit the potential to secure long-term domestic funding for private sector infrastructure projects. ADB will support stakeholder consultation and create public awareness on the benefits of PPP projects. ADB’s involvement in viable PPP infrastructure will provide synergies between the first and second pillar of the CPS. ADB will also provide nonsovereign loans to reforming state-owned enterprises to expose them to alternate sources of finance.
Under the third pillar, human resources are identified to be a critical constraint as demand grows for an educated and skilled labor force. Under human resources development, ADB plans to support secondary education, technical education and vocational training, and to develop a science park to strengthen innovation and research over the CPS period. ADB will assist to improve the quality of secondary education and to provide equal access to education through the 1,000 school concept island-wide.Quality of education will be improved through teacher training, curriculum development, greater use of information communication technology, and improvement in science and technology facilities. ADB will support the skills development program, with a focus on reducing gender disparities, by expanding and improving the quality of technical and vocational institutes and related infrastructure. ADB will help build government capacity over a wide range of activities that are likely to be critical in the next phase of development.
While ADB supports the Government in infrastructure development, private sector development and human capital improvement, neither ADB nor the Governments are the main drivers in developing the middle income economy. Now, private sector is in the driving seats, and business leaders like you will lead the development. Your decision to seek innovation and high productivity is the key to enable Sri Lanka to avoid the middle income trap. I trust that you will guide your enterprises in the right direction and play the vital role in your journey towards a high income country.
Thank you very much.
 World Bank & Commission on Growth and Development. (2008). The growth report: Strategies for sustained growth and inclusive development. Washington DC: World Bank on behalf of the Commission on Growth and Development.
 World Bank (August 2012), Policy Research Working Paper 6165: Learning from China’s Rise to escape the Middle-Income Trap A New Structural Economics Approach to Latin America. Washington DC.