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Why, despite solid progress in human development and in the reduction of consumption poverty, has Sri Lanka's per capita income fallen far behind the dynamic East Asian economies? Sri Lanka's weaker growth performance was the result of several factors, including Sri Lanka's lower investment and (especially) domestic savings rates, its lower average productivity of investment (return on capital), its weak agricultural performance, and its poor export growth.Sri Lanka's weak economic performance, although compounded by the civil war and budgetary imbalance, largely reflects:A stop and go pattern of policy reform, because of political constraints even though the results of reform were generally positive. Weak economic management, resulting in high inflation and a high fiscal and balance of payments deficit. Poor management of public spending. Mixed performance in exchangerate management, with periods of substantial overvaluation. Financial policies that (despite recent improvements) hamper efficient financial intermediation. Prolonged trade protection, followed by selective trade liberalization. Continued distortion in agricultural policies. Inflexible labor markets and, despite Sri Lanka's outstanding track record on human development, problems with the quality of the labor force.To address a substantially unfinished policy agenda, Sri Lanka needs to:Intensify efforts to peacefully resolve civil conflict. Squarely address its macroeconomic imbalances: (1) sharply reduce the fiscal deficit; (2) cut back on public spending (including defense spending, with peace) and redefine spending priorities; (3) improve cost recovery for public services; and (4) continue improving the management of the exchange rate. In trade policy, eliminate most quantitative restrictions, further reduce tariff protection, simplify the tariff structure, and, possibly, reform customs (to reduce leakage and abuse). Rationalize employment, exit, and bankruptcy regulations and procedures. Improve communications between government and the private sector. Make the financial sector more competitive by legislating banking reform, giving state owned banks more autonomy and putting private commercial banks on an equal footing with the two state banks, with the ultimate goal of privatizing the state banks. Strengthen the supervision of banking. Privatize insurance and pension funds to strengthen the capital market. In the agriculture sector: (1) privatize the estate plantations, perhaps through long-term management contracts and the gradual sale of shares in assets, (2) reduce trade protection (especially on rice, wheat, potatoes, chillies, and onions), (3) implement land reform, (4) strengthen agricultural support (for example, irrigation, research and extension, and rural infrastructure), and (5) possibly support rural financing institutions. End government controls on hiring, firing, and wage setting, and rationalize (depoliticize) civil service employment decisions. Make the changes in education needed to improve the quality of the labor force (for example, improve teacher training, courses in science and English as a second language courses, and skills training).This paper a product of the Office of the Director, South Asia Country Department is part of a larger effort in the region to help identify policies for supporting higher growth in Sri Lanka. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Ann Bhalla, room D10071, extension 82168 (34 pages)
