Introduction
Sri Lanka initiated an economic liberalisation programme in 1977- marking a radical departure from an inward-looking, controlled-economy approach to a liberalised, export-oriented strategy that laid the foundation for far reaching reforms in almost all spheres of economic activity. Although during the following decade the reforms transformed the Sri Lankan economy- moving it away from a predominantly agriculture base to an increasingly industrialised and services oriented one- the results during the decades of neo-liberal policies have, by and large, been mixed. The under-performance of the economy has been blamed primarily on the costs incurred by two decades of a prolonged ethnic conflict in the country¹. In 2001, the economy experienced its worst year of performance since the country gained independence in 1948, recording a sharp contraction in GDP growth. It was a culmination not only of rising defence expenditures and adverse external conditions, but also of heightened political instability². In the midst of the economic crisis, the country saw the election of a new government into office in December 2001 whose key objective of resuscitating a deteriorating economic situation centred around efforts to resolve the country's long-standing ethnic conflict and thereby build donor and investor confidence in the economy.

The strategy paid off, albeit to a limited extent. A ceasefire brokered between the newly elected United National Front (UNF) government and the Liberation Tigers of Tamil Eelam (LTTE)- the main protagonists for separatism in the North and East of the country- resulted in a return to some form of 'normalcy' in most parts of the country. The government was also successful in having its policies- both on the political and economic front- endorsed by international financial institutions and the donor community. However, there was little doubt from the outset that major challenges would lie ahead in building mass support for a 'peace deal' that could involve a substantial degree of political devolution in the country and that the government's ability to build support for its peace efforts would be critically dependent on its performance in the economic arena. The complexities of the challenges facing the country have been heightened by the decision to call for snap elections in April 2004, four years before the term of the government was to end. In this climate of uncertainty, this paper attempts to assess Sri Lanka's current economic performance, and the prospects for sustained growth in the medium term in the context of recent political developments in the country.

The Reform Process
Sri Lanka's experiment with market reforms remained limited and partial in nature in the 1980s (though extensive in comparison with the previous policy regime). It included many of the standard reforms of a structural adjustment programme, including liberalisation of trade and payments, rationalisation of public expenditure, de-control of prices and interest rates, promotion of private sector development, foreign investment promotion and financial sector reforms³. While the pace of reforms slowed down considerably from the mid 1980s as the country became embroiled in social and ethnic conflict, there was to be no significant reversal of policy. In fact, the government adopted a 'second' phase of reforms in the late 1980s in order to rejuvenate a flagging economy battered by civil strife. And despite a change of government in 1994, Sri Lanka's commitment to a liberal, open economy continued unabated. In fact, it was to be the first time in the country's post-independence history that a change of government did not herald a reversal of economic policy, generating optimism that a broad convergence on economic ideology between Sri Lanka's major political parties would bring about a measure of policy consistency in the future⁴.

The various phases of reform have seen a significant structural transformation of the economy. The share of agriculture in GDP has declined from roughly 30 per cent at the time reforms were initiated in the late 1970s to 20 per cent by late 1990s. Concurrently, the shares of industry and services sectors have risen, with services dominating with a share in excess of 50 per cent of GDP. Not surprisingly, Sri Lanka's economic growth in the 1990s has come to be driven primarily by the services sector. Despite the changes effected, Sri Lanka's experience with an open, liberal economic policy regime has had its critics. The debate reflects fundamental divisions about the pace and sequence of structural adjustment reforms; the desirability of 'shock therapy' approach versus a more 'gradualist' approach to policy reforms. For some, the staggered and slow pace of the liberalisation process in Sri Lanka- particularly in areas of trade policy and privatisation- in itself has stunted the outcome of liberalisation reforms (Lal and Rajapatirana, 1989; Athukorala and Rajapatirana, 2000). Others have argued that inherent tensions between the stabilisation and structural adjustment programmes in timing, sequencing and problems of transition played a key role in the staggered implementation of the liberalisation process, and that such conflicting tensions in turn imposed domestic social and political pressure on the reform agenda (Dunham and Kelegama, 1997). In fact, perceptions of inequity in access to the benefits of market-driven policies are argued to have been a contributory factor in heightening social and political tensions in the country in the latter part of the 1980s (Dunham and Jayasuriya, 2001).

In response to the social upheaval experienced towards the end of the 1980s, the government adopted a considerably more populist and expansionary policy stance during the 'second wave' of liberalisation during 1990-91. The policy agenda included an ambitious poverty alleviation programme (the Janasaviya Programme) that sought to address the issue of poverty directly, rather than merely leaving it to the 'trickle down' effects of accelerated GDP growth. The government's efforts were supported by an IMF/World Bank Enhanced Structural Adjustment Facility (ESAF) with renewed emphasis on macroeconomic stability and further structural reforms, but retaining the core elements of the poverty alleviation programme. While the economy did indicate an improved outcome in terms of GDP growth in the two decades of liberalisation, most data suggest that poverty may not have changed much over the period (World Bank, 2002). Sri Lanka's experience in fact, is broadly in line with emerging international evidence that the prescribed orthodox macroeconomic policies of the IMF/World Bank had limits in terms of how far it could take countries on the path toward equitable growth.

The mixed results achieved under neo-liberal programmes have also come to be acknowledged by international financial institutions. While stabilisation and structural adjustment were considered to have had a measure of success, their inability to ensure sustainability of renewed growth and address core concerns of reducing the poverty gap within and between nations were being questioned. While poverty alleviation remained a core concern, the nuance was more on the increase in inequality and its consequences⁵. With the emphasis on closing the disparity between the rich and poor countries, the search for new answers recognised the need for a broader set of reforms- referred to collectively as 'second generation' reforms- focused around the need to develop the institutional capacity for reforms. Questions on the structure of the right institutions, improvement of the administrative, legal, and regulatory functions of the state, and incentives and actions required for private sector development were key concerns. Nonetheless, international financial institutions such as the IMF and the World Bank have been at pains to argue that the 'first' and 'second' generation reforms were not sequential and early attention to monetary policy, and growth and stability are seen as preconditions for attacking the question of poverty through a broader set of reforms aimed at sustainable and equitable growth. The IMF and the World Bank have, therefore, created a new lending programme called the Poverty Reduction and Growth Facility (PRGF) replacing the existing Enhanced Structural Adjustment Fund (ESAF) as an answer to their critics. Its aim is to broadly explore alternative approaches to the reform programmes and to commit to poverty reduction as an explicit goal of lending and macroeconomic policies.

Current Performance
Sri Lanka experienced a fairly volatile period of economic growth in the latter half of the 1990s that was to culminate with the country's worst year of economic performance in 2001. Not only was the country burdened with intermittent drought conditions that lowered agricultural production and contributed to power shortages, but global economic conditions were also volatile with the East Asian financial crises of 1997-98 and thereafter, the general slowdown in the global economy. In addition, renewed fighting in the North and East of the country⁶ strained fiscal management to the point that Sri Lanka had to seek IMF balance of payments (BOP) assistance in 2001.

Table 1: Selected Macroeconomic Indicators

		1998	1999	2000	2001	2002
Population growth Per capita GNP Unemployment	% $ %	1.3 865 9.2	1.5 851 8.9	1.4 881 7.6	1.4 826 7.9	1.5 858 9.2
GDP growth Agriculture Industry Services	% % % %	4.7 2.5 5.9 5.1	4.3 4.5 4.8 4.0	6.0 1.8 7.5 7.0	-1.5 -3.4 -2.1 -0.5	4.0 2.5 1.0 6.0
Investment Savings	% of GDP % of GDP	25.1 19.1	27.3 19.5	28.0 17.4	22.0 15.8	21.3 14.6
Govt. expenditure Govt. revenue Fiscal balance Public debt DSRa	% of GDP % of GDP % of GDP % of GDP %	26.3 17.2 9.2 90.8 13.3	25.2 17.7 7.5 95.1 15.2	26.7 16.8 9.9 96.9 14.7	27.5 16.7 10.8 103.2 13.2	25.4 16.5 8.9 105.3 13.2
Rate of inflation Interest rateb Exchange rate ASPIc	% % Rs/US$ 1985=100	9.4 15.0 67.8 597.3	4.7 13.5 72.1 572.5	6.2 20.0 80.1 447.6	14.2 14.0 93.2 621.0	9.6 11.8 96.7 815.1
Exports Imports Current A/C on BOP FDI Portfolio External assets Tourist arrivals	$ million $ million % of GDP $ million $ million months of imports No.	4798 5889 -1.4 137 -24 5.9 381063	4610 5979 -3.6 177 -13 5.2 436440	5522 7320 -6.4 173 -45 3.5 400414	4817 5974 -1.5 82 -11 4.5 336794	4699 6106 -1.6 230 25 4.9 393171
Notes: a. DSR=Debt Ser vice Ratio (percent of exports of goods and services); b. Reverse Repo rate; c. ASPI=All Share Price Index. Source: Central Bank of Sri Lanka, Annual Report, various issues.

Without exception, the experience has been that actual expenditure overshoots the forecast target, while total revenue collected falls short of the anticipated amount. On the expenditure front, with defence expenditures and interest payments on debt continuing to absorb a large share of government resources (with debt servicing alone accounting for 40 per cent of total revenue), room for expenditure cuts has remained limited. Where the opportunity has existed in rationalisation of public sector institutions and workforce there has been a lack of policy commitment over the years to institute much needed reforms.

Sri Lanka has made considerable progress in fiscal consolidation over the past two years¹⁰. Fiscal responsibility- a key concern of lending conditionalities imposed by the IMF/WB- has been adhered to by bringing the overall fiscal deficit down to under 8 per cent of GDP in 2002 with a further anticipated reduction to 7.5 per cent in 2003. Expenditure targets have been maintained by a commitment to freeze recruitment to the public sector- a favoured option by governments to generate employment- and public sector salaries. The government was assisted in its efforts by a marked relaxation of the spiralling defence expenditures of the past. On the revenue front, the key change has been a progressive transition from the prevailing Goods and Services Tax (GST) of 12.5 per cent to a Value Added Tax (VAT) of 15 per cent. On a more adverse note, however, the past practice of bridging the deficit by curtailing capital expenditure was continued which does not bode well for sustained economic growth in the longer term.

With the narrowing of the fiscal deficit, the government was able to progressively reduce its borrowing requirement. The manner in which deficits are financed hold implications for Sri Lanka's debt management. It is of particular concern at a time when the outstanding public debt stock has continued to increase for a fifth consecutive year from 85.8 per cent of GDP in 1997 to 105.3 per cent in 2002¹¹. The reduction in the domestic borrowing requirement, although marginal, contributed to rein in inflation in the economy. The rate of inflation has dropped sharply from over 14 per cent in 2001 to under 7 per cent by 2003. On the monetary front, with the improvement in external reserves and general slowdown in inflation, the government was able to progressively reduce interest rates in the hope of encouraging borrowing for investment purposes. Its low interest rate regime was helped by the fact that the exchange rate also held steady in 2002 on the strength of higher inflows of foreign exchange into the country. Despite the progressive reduction in interest rates, credit growth to the private sector began to pick up sharply only towards the end of 2002 owing to a residue of domestic political uncertainty and sluggish market conditions.

The improvement in economic performance from 2002 onwards was to some extent generated by the 'peace' process. The cessation of hostilities not only saw some renewal of agricultural output in the war ravaged North and East of the country (contributing to easing supply constraints and thus helping to keep inflation down), but, more significantly, a relative boom in Sri Lanka's tourism sector. Tourist arrivals exceeded 500,000 in 2003, registering an increase over the previous highest number of arrivals recorded since 1999. The other area that saw a significant improvement in performance was foreign direct investment (FDI) which saw a sharp increase from US$ 82 million in 2001 to US$ 230 million in 2002. As a percentage of GDP, at 1.4 per cent, it is the largest inflow that Sri Lanka has experienced since 1993 when FDI inflows accounted for 1.8 per cent of GDP.

The Colombo Stock Exchange (CSE) also saw a significant improvement on the heels of the return to power of a government looked on more favourably by the private sector. Most notably, the trend towards net outflow of foreign portfolio investment seen since 1998 was reversed in 2002. The anticipation of economic recovery (and expected improvements in corporate profits), bolstered by the cessation of hostilities and an improved environment for investors, were among key factors that contributed positively to the recovery. As a result, the CSE saw an unprecedented bull run, driven primarily by local buying, indicative of high liquidity in the domestic business sector and the decline of commensurate returns from fixed income instruments.

The recovery on the export front, particularly of manufactured exports, was less impressive. The Sri Lankan economy retains a structural weakness in its overwhelming dependence on the garments sector, accounting for over 40 per cent of total industrial output and 50 per cent of export earnings. Given a high concentration of markets (with the U.S. market alone accounting over 60 per cent of exports), the garments sector remains highly vulnerable to external demand conditions. While there were promising indications of a recovery in export earnings from the latter half of 2002, the international competitiveness of the sector is of concern as it prepares to meet the challenges of a quota free environment from 2005. The Sri Lankan garments industry has primarily been quota driven and has benefited from the Multi Fibre Arrangement (MFA). With the anticipated phase-out of the MFA at the end of 2004, the outlook for the sector remains fairly bleak. Even on a global scale, Sri Lanka's garment export earnings have lagged behind other competitors (Table 2). Countries such as Bangladesh and Mexico which were earning comparable amounts from garments exports in 1990 have improved their position considerably in relation to that of Sri Lanka's garments sector earnings in the 1990s.

Table 2: Exports of Garments of Selected Economies, 1990-2001

	US $ Million					Share in total merchandise exports (%)
	1990	1995	1999	2000	2001	1990	2001
Bangladesh China India Indonesia Jordan Mexico Sri Lanka Turkey	643 9,669 2,530 1,646 11 587 638 3,331	1,969 24,049 4,110 3,376 29 2,731 1,758 6,119	3,721 30,078 5,153 3,857 58 7,772 2,287 6,516	4,244 36,071 6,030 4,734 115 8,631 2,812 6,533	5,111 36,650 n.a. 4,531 296 8,011 2,398 6,627	38.5 15.6 14.1 6.4 1.0 1.4 33.4 25.7	78.3 13.8 14.2 8.0 12.9 5.1 49.8 21.2

Nevertheless, in overall terms, Sri Lanka appeared on the road to regaining macroeconomic stability and renewed growth momentum. However, the underlying political instability that had dogged the government since its election, manifested in November 2003 with a decision by the Executive President to wrest control over three key ministries of the government (including the all important one of defence). In a follow up action, the President who has authority under the Constitution to dissolve Parliament after one year in office, exercised her prerogative and called for snap elections in April 2004. The uneasy cohabitation between the President and Parliament that had generated some degree of uncertainty (given the looming threat of dissolution of Parliament) has opened a new chapter in Sri Lanka's economic and political future.

The Challenges Ahead
Whichever government is elected into office, there are fundamental challenges to be met on the economic front. While estimates of poverty levels in the country differ, a widely accepted conservative estimate is that nearly 25 per cent of Sri Lanka's population remains below the poverty line (GOSL, 2000). Although the incidence of poverty is estimated to have reduced by 2 per cent over the period 1985-1995, population growth has meant that the absolute number of poor has not decreased over time. Poverty in Sri Lanka also remains largely a rural phenomenon with the incidence of poverty being highest in rural areas where the majority of the population (80 per cent) lives. About 27 per cent of the rural population is estimated to be poor compared to only 14 per cent of the urban population. Equally worryingly, Sri Lanka continues to be burdened by a relatively high rate of unemployment of around 9 per cent of the labour force, with the highest rates being reported among the educated youth. The unemployment numbers also mask the fact that Sri Lanka exports nearly one million of its labour force, particularly as unskilled female labour, to the Middle East, with considerable adverse socio-economic implications for society at large¹².

The UNF government has been open to the charge that while it was able to restore some degree of soundness to macroeconomic 'fundamentals' by eschewing populist fiscal measures, there were little visible benefits trickling down to the masses¹³. Arguably, the priority in the midst of Sri Lanka's sharpest economic contraction was to resuscitate growth. And the economic programme, weighted as it was in the direction of supporting overall economic growth, was likely, at least initially, to benefit the more prosperous sectors. Only as fiscal soundness was restored and the growth momentum took hold, would the government have been in a position to address more acutely the wider socio-economic inequities in society. Unfortunately, that hypothesis may not get an opportunity to be tested as Sri Lanka once again finds itself having to re-start the implementation process after the April 2004 elections.

The outlook for the economy will be critically dependent on the composition of the new government. It is plausible to assume that the country's post-2001 economic recovery which is still in its first fragile state may be subject to some reversal of fortune with a change of government. Much of the donor funding committed to the country is tied into the peace process. One reason cited by the President for the dissolution of Parliament was on the grounds of 'national security' where the UNF was viewed as having conceded essential ground during the peace process. The formation of a new alliance between the political party headed by the President, the People's Alliance (PA), and the Janatha Vimukthi Peramuna (JVP) with a history of revolutionary and nationalist ideology may place the continuation of the peace process under some uncertainty. Donor commitments may, therefore, have to be renegotiated, delaying not only the implementation of reconstruction and rehabilitation efforts of the war ravaged North and East of the country, but also much needed infrastructure projects in the rest of the country. In addition, the economic policies of the JVP tending as it does towards more 'protectionist' rhetoric is likely to scare off potential private investment (both local and foreign) in the Sri Lankan economy at least in the immediate short-term, until a clearer picture of their economic policies is spelt out.

Given that much of the recovery has been driven by the peace dividend, albeit indirectly, any resumption of hostilities (or the likelihood of such a resumption in the near future) will hold significant implications for sustaining the growth momentum. Much of the recovery has been the result of a resurgent tourism sector and inflows of foreign capital into the country. Any deceleration in foreign exchange earnings will quickly reverse an improving balance of payments position, threatening the stability of the exchange rate. In addition, if a new government adopts more 'populist' measures, the fiscal consolidation of the past two years may also come under pressure with attendant implications for macroeconomic stability.

Notwithstanding the above, even if the elections were to return the UNF government back into power, there is little likelihood of political stability returning to the country in the immediate future. The government would still have to contend with the Executive President until the next Presidential elections in 2005-06¹⁴. Thus, the uneasy and progressively more bitter cohabitation would continue until a clear winner emerges from the next Presidential elections. Only if the UNF were to gain control of both the Presidency and the Parliament, would the party be guaranteed of serving out its term and implementing its agenda on both the peace and economic fronts. But it would be misleading to assume that the process would not be without inherent risks to the political stability of the country. Unless the peace process engages the confidence of all communities and the government's commitment to market-oriented economic policies are perceived to generate equitable benefits, there is a real danger that the country will find itself being consumed by social disruption resulting from loss of public confidence in government and an economy that is not able to meet the aspirations of the people at large.

(Dushni Weerakoon is Fellow at the Institute of Policy Studies of Sri Lanka).

End Notes

1.	It has been estimated that on conservative assumptions, the war may have cost the equivalent of 1.7 times Sri Lanka's 1996 GDP (see Arunatilake et al., 2000).
2.	A coalition of parties, the Peoples Alliance (PA), was elected for a second term in office in 2000. The PA entered into an alliance with a Marxist oriented party, the Janatha Vimukthi Peramuna (JVP) in 2001, but was unable to sustain a majority in Parliament and fresh elections were called in December 2001.
3.	These policy reforms have been well documented. See Lal and Rajapatirana (1989), Cuthbertson and Athukorala (1991), Athukorala and Jayasuriya (1991).
4.	The absence of such policy continuity