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Cablegate: Wb/Adb Report Highlights Constraints in Sri

This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 03 COLOMBO 001424

SIPDIS

STATE FOR SA/INS

E.O 12958: N/A
TAGS: ECON EINV ETRD EAID CE ECONOMICS
SUBJECT: WB/ADB report highlights constraints in Sri
Lanka?s investment climate.

1. Summary: According to a recent Asian Development Bank
(ADB)/World Bank (WB) investment climate assessment, Sri
Lankan firms have identified sharply deteriorated
infrastructure (electricity and transport) and cost of
finance as major constraints for doing business. Urban
firms also cite economic policy uncertainty, macro economic
instability and labor regulations as major concerns.
Marketing is a major issue for rural firms. End Summary

First scientific study

2. A joint WB and ADB investment climate assessment for
Sri Lanka was released on June 28, 2005. The study
surveyed 450 urban and 1,300 rural firms during 2003/2004.
It aimed to understand the most severe obstacles in Sri
Lanka?s investment climate and provide information to
policy makers on the areas most in need of reform. Sri
Lanka suffers from low levels of investment and needs to
raise investment significantly to reduce poverty.
According to WB sources, the study provides the first
scientific analysis of the investment climate and confirms
issues previously identified by the bank through anecdotal
evidence as factors affecting the business climate. These
issues have also been raised periodically by WB sector
specialists. According to these sources, as businesses
perceive the problems cited in the study as constraints, it
is very unlikely that they will expand their businesses
unless the problems are addressed. Similarly, these issues
will discourage new investors, who are sure to hear this
story when evaluating the investment climate.

Key constraints

3. Urban and rural firms face quite different constraints
except for a few common issues. Over 40 percent of urban
firms cited electricity as the biggest constraint for
investment followed by policy uncertainty, macro
instability, cost of finance and labor regulations. Rural
firms cited transport problems as the key constraint
followed by cost and access to finance and marketing.
Rural firms have identified lack of electricity as the
fifth biggest constraint. The survey also generally lists
labor regulations and infrastructure deficiencies as the
most severe constraints affecting FDI. Other perceived
constraints to FDI were concerns about the peace process,
and economic and regulatory policy uncertainty.

4. Electricity: Not surprisingly, urban firms cite
electricity as the most serious obstacle to doing business.
Electricity is concentrated in urban areas but, where grid
electricity is available, the cost is high and supply
unreliable leading nearly 75 percent of urban manufacturing
firms to own a generator. Sri Lankan businesses pay higher
electricity rates than in US and have the most expensive
electrical rates in the region. Electricity represents an
entry barrier to rural firms. Less than 70 percent of
rural enterprises use electricity from the national grid,
yet those firms connected to the grid had significantly
higher factor productivity than firms not connected.

5. Policy uncertainty: Macro economic and political
instability and policy uncertainty are cited as major
constraints by over 30 percent of the urban firms. They
claim that planning is impossible, and that investment
decisions are postponed. Rural firms were not aware of or
did not pay much attention to policy constraints or macro
instability.

6. Transport: Rural firms cite transport as the biggest
constraint. While Sri Lanka has a dense road network, as
much as 90 percent of the paved roads are in poor
condition, due to lack of maintenance, resulting in big
costs on business and individuals. Transport conditions
are also skewed among regions with the western province
(which includes the capital, Colombo) enjoying greatest
mobility. Due to transport bottlenecks including low
travel speeds, almost 40 percent of all agricultural
produce spoils before reaching the market. Transport is
also a constraint for urban manufacturing firms as traffic
congestion and poor services (including frequent and sudden
strikes and work stoppages) lead to long delivery times,
absenteeism and low productivity. Transport is a big
constraint for the tourism sector.

7. Finance: The cost of finance is a major constraint to
both rural and urban firms. In the urban sector, large and
medium firms rely heavily on retained profits for both
working capital and investment purposes. Banks finance
about 35 percent of their working capital and about 15
percent of their new investment. The survey reveals that
bank financing is heavily reliant on collateral (land,
building and machinery), a major drawback for small and
medium-sized industries and some rural firms. Financing
problems affect small urban firms most severely. These
firms, unable to provide collateral, are mainly funded by
equity and savings. Small urban firms pay the highest
interest rates. Large firms can bargain for competitive
rates and rural firms benefit from subsidies. WB sources
attribute high cost of finance to various factors from
persistent government deficits and borrowing by state-owned
enterprises to high non-performing loans and rigid labor
laws that hinder both private and public banks? abilities
to restructure and become efficient.

8. For rural firms, both cost and limited access to
finance were major constraints. Access to formal finance
in rural areas, particularly for investment purposes, is
very low. Private commercial banks account for about two
percent of investment finance and state banks account for
about six percent. Rural firms obtain most of their funds
from savings, family and friends and not from formal
finance sources. Rural credit institutions and various
micro finance schemes, despite their widespread presence in
rural areas, fund a very modest share of rural investment.
A major problem for rural financing is also lack of
collateral. Most financial institutions require collateral
in the form of land. However, rural entrepreneurs do not
own land or are often unable to provide clean ownership
records. Rural firms face widely dispersed interest rates,
depending on the source of finance.

9. Marketing: Limited access to markets and lack of
demand are major problems faced by many rural firms. They
have fewer contacts with larger firms and buyers. Only
large rural firms take advantage of subcontracting. Poor
transport facilities, roads and telecommunications compound
marketing problems and access to information. Another
major marketing issue is the low quality of goods produced
by rural firms. On the other hand, urban firms have gained
significantly from international ties. Firms with foreign
ownership, foreign suppliers or foreign professionals are
more productive. Similarly, exporting firms recorded
faster growth and higher productivity. International ties
have also facilitated the acquisition of technology.

10. Governance: Somewhat surprisingly, the survey reveals
that governance is not seen as a major problem. It is easy
to start a business and also relatively easy to run a
business once started. Unusually, more than half of rural
firms are registered. Only 15 percent complained of
problems in tax administration, crime, customs, or
corruption. According to World Bank sources involved with
the study, although there is a general perception of high
levels of corruption in the society -- partly attributed to
high profiled media reports, more than half of urban and
rural firms reported that corruption was not a problem.
Enforcement of contracts, however, is a problem. More than
half of rural and urban firms reported that the legal system
was not a major problem, but that the legal process was slow.

11. The study urges the government to give thought to
differences in the rural and urban investment climate when
designing new policies and to give particular attention to
the development of rural infrastructure and expanding
access to markets for rural entrepreneurs. Rural
entrepreneurs have complained that their voices are not
heard in the policy making process. Improvement to the
rural investment climate is important given that Sri Lanka
remains largely a rural society with 85 percent of the
population living in rural areas. A large proportion of
these rural households depend on the non-farm sector for
employment and income. Total value added of the sector was
equivalent to about 12 percent of GDP in 2003.

12. Northern Firms: Firms in the war affected north and
east face significantly different problems. Over 75
percent of them cited public infrastructure (postal
services, water, transport and road conditions) as a major
constraint. The insecurity has also imposed a high cost.
As many as 20 percent of firms incurred losses due to crime
and violence in the past year, compared with just 1-2
percent in the rest of the country.

Main recommendations

13. While recognizing permanent peace as the most
important ingredient to improve the investment climate, the
survey identifies five policy areas for urgent action and
lists specific steps in each of these areas.

The five policy recommendations are given below:

-- Improving access to and quality of energy and transport

-- Reducing cost of finance and improving access to it.

-- Improving labor market flexibility (urban)

-- Improving access to major markets (rural)

-- Improving policy certainty and macro economic
stability (urban)

14. The full report is available on www.worldbank.lk

Entwistle

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