US embassy cable - 05COLOMBO1424

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