US embassy cable - 04COLOMBO1271

UNCLAS SECTION 01 OF 03 COLOMBO 001271 
 
SIPDIS 
 
DEPT FOR SA/INS 
DEPT FOR EB/TPP/ABT (EHEARTNEY) 
DEPT PASS USTR 
 
COMMERCE FOR ARI BENAISSA 
 
E.O. 12958: N/A 
TAGS: ECON, ETRD, EINV, KTEX, ELAB, CE, ECONOMICS, External Relations 
SUBJECT: Potential Fallout of MFA Expiration in 2005 
 
1.  Summary:  There is heightened anxiety in Sri Lanka's 
apparel sector, as expiration of the Multi-Fiber 
Arrangement approaches in January 2005.  Sri Lanka's top 
end producers, controlling about 70% of exports, are 
expected to be the least affected, as they have gone high- 
tech, cut costs and lead times, and have formed strong ties 
with buyers.  The absence of sweatshops, and the existence 
of numerous firm-level worker welfare programs have 
prompted Sri Lanka to use social compliance as a key 
marketing tool.  On the negative side, Sri Lanka's lack of 
a fabric base, distance from markets, and high electricity 
charges could pose a challenge to the industry (even to 
large manufacturers) trying to be competitive post MFA. 
The plight of small and medium industries is very 
uncertain.  Factory closures and substantial job losses 
will be certain, but cannot be quantified.  A substantial 
number of Sri Lankan expatriate garment factory workers 
abroad will also return, compounding the problem.  Sri 
Lanka is yet to find a replacement for apparel as the key 
growth engine in the industrial sector and key employment 
generator.  End Summary. 
 
Industry response 
----------------- 
 
2.  With no US-Sri Lanka FTA in sight and the January 1, 
2005 expiration of the Multi-Fiber Arrangement (MFA) less 
than 6 months away, there is increased anxiety in the 
apparel industry regarding Sri Lanka's prospects.  Hoping 
against hope, stakeholders in the apparel industry - under 
the Joint Apparel Associations Forum (JAAF), formed in 2002 
to focus on meeting the 2005 challenge - are still holding 
on to their goal of increasing apparel exports from $2.4 
billion in 2002 to $4.5 billion in 2007.  JAAF is working 
to improve market access, marketing and designing 
capabilities and labor standards, establish backward 
linkages, increase productivity and lower costs.  Their 
strategy is to build a base here for four specific product 
lines (active/sports wear, casual wear, children's wear, 
and intimate apparel) and to move up-scale to department 
stores and specialty stores.  JAAF expects their efforts to 
help transform the industry from a manufacturer to a 
provider of a fully integrated service.  Plans are underway 
to set up three fabric mills, including a giant French 
nylon lace plant.  JAAF also plans to improve the image of 
the Sri Lankan industry abroad, especially its adherence to 
labor and environmental standards and focus on corporate 
social responsibility. 
 
MFA phase out 
------------- 
 
3.  Even while these steps are being taken to meet the MFA 
threat, there is growing concern about the many challenges 
posed by MFA's phase out.  A 2002 study showed that the top 
12% of companies operating about 100 factories account for 
nearly 72% of garment exports.  These large-scale 
manufacturers have begun programs for upgrading technology 
and skills and some of them boast world class manufacturing 
facilities and professionals.  Many have succeeded in 
shifting to the high-end of the global apparel market, but 
most others have not made the necessary changes to confront 
global competition.  The negative effect of the MFA phase 
out, therefore, is likely to be felt most severely by the 
small and medium enterprise (SME) sector, which represents 
about 70% of garment factories.  According to a recent 
report, 80% of the small and medium scale factories operate 
on thin margins and could be easily forced out of business 
once prices fall. 
 
4.  Further, over 60% of Sri Lanka's garment exports to the 
US currently depend on quotas.  Signs of shifting 
competitiveness have already begun to emerge.  According to 
a recent OXFAM study, Sri Lanka's exports to the US in 
products liberalized in stage 3 of the ATC (on January 1, 
2002) have declined by over 50% between 2001-2003. 
Similarly, Sri Lankan exports of these products to EU 
dropped by over 20%.  A closer look at data reveals that 
Sri Lanka has lost market share to China for some products, 
while in some other categories (high quality, up-market 
products) Sri Lanka has gained market share. 
 
Impact on employment 
-------------------- 
 
5.  There are also concerns regarding the impact of quota 
expiration on employment.  Currently, the industry directly 
employs 339,000 people, but over a million jobs depend on 
the industry.  There are no comprehensive studies on the 
phase-out's effect on labor.  Some estimates place job 
losses in the range of 100,000 to 150,000, including around 
50,000 Sri Lankan expatriate garment factory workers in 
Middle East and Maldives who will return as those locations 
no longer receive quota concessions.  (Note: some are 
returning to factory jobs with their current employers, who 
are simply shifting production back to Sri Lanka.  Others 
will certainly be unemployed as a result of the change. End 
note.)  Recently, worker rights groups have started 
discussing the transition, and have requested ILO help to 
develop a plan to deal with it. 
 
6.  The social consequences of these potential job losses, 
especially in rural areas, remain a concern, and little has 
been done to actually find sources of alternative 
employment or provide retraining.  The contribution of the 
apparel industry to the rural and semi-urban economy has 
been significant.  Some factories are located in rural 
areas (a result of the 1992 200 Garment Factories incentive 
program sponsored by the GSL) and most of the machine 
operators come from rural areas.  According to ILO and NGO 
contacts, awareness of MFA phase out among factory workers 
and their dependants is also low. 
 
7.  In addition to job losses, a substantial reduction  in 
the apparel sector could ripple through supporting sectors. 
It would be felt in export earnings, in port, air services, 
cargo services, the packing industry, inland transport, and 
the banking sector. 
 
Labor Standards 
--------------- 
 
8.  The current discussion on the phase-out has also forced 
the sector to rethink labor relations.  Most of the apparel 
industry is non-unionized, a result of past government 
regulations prohibiting union activities in Export 
Processing Zones (EPZ) and a general reluctance by 
employers to support unions, due to their heavy 
politicization and culture of violence.  Instead, the 
Government, through the Board of Investment (BOI), 
supported the formation of employee councils, which have 
worked well in protecting labor welfare.  (ILO has ruled 
that trade unions and employee councils can co-exist.) 
Larger factories generally provide very good facilities to 
workers including good working environments, free or 
subsidized meals, free medical facilities, free transport, 
and recreation.  Some even provide free hostel facilities, 
and training opportunities in IT and English. 
 
9.  The EU has recently granted enhanced tariff concessions 
to Sri Lanka on the basis of its progress towards 
implementing ILO core labor standards.  Sri Lanka has 
adopted all eight standards, but implementation of clauses 
on freedom of association and collective bargaining has 
been weak due to low tolerance of trade unions in the EPZs. 
The BOI and the JAAF are working together to improve union 
operations. 
 
Strengths and weaknesses 
------------------------ 
 
10.  Sri Lanka seems to be better prepared than some of the 
countries facing the MFA phase out as a result of 
stakeholders forming JAAF in 2002.  Following the JAAF 
strategy, leading companies have already gone upscale and 
consolidated their businesses.  For instance, MAS Group, 
the largest manufacturer in Sri Lanka, is the single 
largest vendor worldwide to Victoria's Secret.  The second 
largest manufacturer, Brandix, has consolidated several 
business units under one umbrella to attain economies of 
scale.  These companies plan to exploit Sri Lanka's 
advantages, such as low labor costs (USITC studies indicate 
hourly labor cost in Sri Lanka is about 40 US cents, 
compared with 69 cents in coastal China and 57 cents in 
India), a skilled and easily trainable workforce, positive 
reputation, and strong relationships with buyers.  Going 
forward, Sri Lanka can benefit by exploiting these 
advantages to create a positive perception among buyers and 
consumers and position the country as a labor compliant 
manufacturer with high social responsibility standards. 
Meanwhile, the GSL is considering a relaxation of rules on 
EPZ factories, to allow them to engage in subcontracting to 
larger manufacturers, which is currently prohibited. 
 
11.  On the negative side, Sri Lanka does not enjoy 
economies of scale to support a fabric base and fabric is 
sourced from India, China, Hong Kong, Korea and Indonesia. 
In addition, the distance from major markets (US and EU) 
has resulted in longer lead times required to get goods to 
store shelves.  The high cost of electricity, the lack of a 
good Electronic Data Interchange (EDI) system for export 
documentation, and limited diversification of the economy 
to absorb any fallout from MFA phase out are also serious 
concerns.  Sri Lanka's strict labor termination laws will 
also hinder corporate restructuring and a smooth transition 
to the new era. (Note: labor laws have been under review, 
but a revamp of worker termination rules is politically 
very difficult. End note.) 
 
12.  Comment:  As Sri Lanka faces increased competition 
after January 2005, garments may no longer be the growth 
engine in the industrial sector, and also could be a drag 
for services growth, as the garment industry feeds many 
other sectors.  Therefore, a contraction in the industry 
does not augur well for Sri Lanka's economy.  Although 
there have been efforts to boost tourism, IT, rubber, and 
to take advantage of Sri Lanka's strategic location in the 
east west sea routes, nothing seems poised to take over 
readily from apparel, which is Sri Lanka's largest 
industrial sector (contributing to 65% of industrial 
exports, 50% of total exports and sustaining over a million 
jobs). 
 
13.  The dismantling of a large number of SMEs will be 
quite disheartening to the GSL, as it has announced 
development of the SME sector a top priority.  Nonetheless, 
Sri Lanka has been thinking about the MFA expiration and 
its consequences for some time (it was one of the countries 
to oppose expiration during ATS negotiations).  The 
industry's focus and determination to increase productivity 
and reduce time to market should help it gain long-term 
strategic advantages.  Despite a commitment to excellence, 
the question remains, will China's and India's vast sizes 
simply overwhelm smaller suppliers?  End Comment. 
LUNSTEAD