Trade Liberalization in Sri Lanka: Effects on Exports and Imports

8/21/2019 Trade Liberalization in Sri Lanka: Effects on Exports and Imports

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SriLankanJournalofBankingandFinance(SLJBF),Vol.01,No.01,2013,ISSN2349271

37

TRADE LIBERALIZATION IN SRI LANKA: EFFECTS ON EXPORTS AND

IMPORTS

Herath H.M.S.P.1, Cao Liang2, Cheng Yongbing3

1PhD CandidateSchool of Business Administration

Zhongnan University of Economics and Law, Wuhan - P.R. ChinaE mail:[email protected]

2ProfessorSchool of Business Administration, Zhongnan University of Economics and Law

Wuhan - P.R. ChinaE- mail: [email protected]

3Associate Professor

School of Business Administration, Zhongnan University of Economics and LawWuhan - P.R. China

E-mail: [email protected]

ABSTRACT

This paper examines the process of Sri Lankas trade liberalization and its impact on exports andimports. Secondary data is used to estimate effects of trade liberalization on exports and imports forthe period from 1970 to 2011. In estimating impacts of trade liberalization on export and importsectors, total time period is divided into two sub periods of before trade liberalization i.e. (1970 1977) and after trade liberalization i.e. (1977 2011). The study mainly employs simple and multipleregression models to disentangle trade effects. The main empirical results suggest that growth rate of

total exports and imports are higher during the closed economic period than in the open economicperiod.

Key Words: Trade Liberalization, Exports, Imports

1. INTRODUCTIONThe movement toward free trade by reducing tariff and non-tariff trade barriers is a major driving

force in most economies of the world to achieve higher economic performance. Sri Lanka started to

open the economy in 1978 after following import substitution industrial (ISI) policies prior to 1977

with the expectation of rapid development of the country. Export expansion is one of the major

objectives of trade liberalization policies of Sri Lanka. With expectation of export led growth, policy

makers have eliminated various trade restrictions after 1977. Especially reduction and simplification

of tariffs, quantitative restrictions and exchange rate policies are the major tools in moving to free

trade. First, Sri Lanka moved to managed floating exchange rate system from fixed exchange rate

system in 1978. Moving to managed floating exchange rate system, the country expected expansion of

exports and contraction of imports with depreciation of the domestic currency. Another important

policy implemented to liberalize the trade of Sri Lanka was the simplification and rationalization of

tariff structure of the country. However, expected results on export and import sectors of moving the

country for free trade has become irregular during the last three decades. Policy makers need to know


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the answers to several questions. First, what is the effect of trade liberalization on overall exports and

imports of the country? Second, what impact does trade liberalization creates on the composition of

exports and imports? Third has trade liberalization influenced on direction of trade of the country? In

this context, the main objective of the study which is to extricate the effect of trade liberalization on

export and import of Sri Lanka is of great importance to analyze and would be more beneficial for the

future trade reforms of the country.

In international trade literature, two broad categories of empirical studies prevail on tradeliberalization, exports and economic performance. First category include empirical studies of largemulti country studies which examine the processes of trade policy reform within individual countries,and its consequences in detail (e.g. Little, Scitovsky and Scott, 1970; Balassa, 1978; Krueger, 1971;Bhagwati, 1978; and Michaely et al. 1991). Second category consists of econometric studies whichuse time series analysis, cross-section analysis, or panel data analysis (Santos and Paulino, 2002;Leamer, 1988; Edwards, 1998).

Research on identifying specific relationship between trade liberalization and export growth givesmixed results. Some studies confirm that countries which embarked on liberalization programs haveimproved their export performance e.g. India (Joshi and Little, 1996); Latin American countries(Bleaney, 1999), and Bangladesh (Ahmed, 2000). Other studies have found only a weak relationship(e.g. Agosin, 1991; Clarke and Kirkpatrick, 1992; Greenaway and Sapsford, 1994; Shafaedin, 1994,and Jenkins, 1996). The most interesting and comprehensive recent study is that by Santos-Paulino(2002) who takes a panel of twenty-two developing countries that undertook significant tradeliberalization during the period 1972-97. Trade liberalization is measured by the ratio of exportduties (as a measure of the tax on exports), and by a dummy variable which takes the value of one inthe year when significant liberalization took place (and thereafter) and zero otherwise. Panel dataestimation techniques are then applied to the determination of export growth in these twenty-twocountries over the period of analysis, using as independent variables the real exchange rate, thegrowth of world income, and the measures of liberalization. Depending on the equation specification,the central estimate is that trade liberalization has raised export growth by one to two percentagepoint. Also it is interesting to note that the income elasticity of demand for exports always dominatesthe price elasticity. Whereas the income elasticity of exports averages about 1.5, the price elasticity is

not higher than 0.16. In these circumstances, currency devaluation would not improve exportearnings from the demand side.

Trade liberalization of an economy doesnt exactly imply faster export growth of the country but inpractice the two variables appear to be highly correlated. The impact of trade liberalization oneconomic growth probably works mainly through improving efficiency and stimulating exports whichhave powerful effects on both supply and demand within an economy (Thirlwall, 2002). In studyingeffect of trade liberalization on exports and imports, Lopez (2005) has carried out a study in Mexicoto disentangle the effect of trade liberalization. Researcher found that Mexicos trade liberalizationhas positively affected on the performance of exports and imports by a similar magnitudes. However,he found Mexicos imports have responded earlier than its exports. Also, the study concludes thatdiscriminatory trade liberalization policies with North American Free Trade Agreement (NAFTA) hasnot significantly affected on exports. But there is a significant effect on import growth.Overview of trade policy reforms

After gaining independence in 1948 from British Colonialists, economic policies of Sri Lanka havechanged time to time with changes in political environment and some external shocks. Since 1948, thegovernments which were in power have implemented inward-looking economic policies and out-wardlooking economic policies time to time. During the 1948 1955 period, Sri Lanka experienced freetrade era. Favorable balance of payment condition appeared due to Korean War boom in 1951/52 andtea boom in 1954/55 was the major reason that leads Sri Lanka for liberalized trade policies (CBSL,1998). However this favorable balance of payment situation was not continued until the end of 1950s


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and country marked the beginning of closed economy in 1956. As a result of deterioration of balanceof payment situation and some political changes, the country began import substitution industrialstrategy (ISI) in 1956.

From 1956 to 1965, the government which were in office implemented ISI strategy to overcomebalance of payment difficulties and to achieve self sufficiency in rice and other essential agriculturalgoods. During this period the restrictive measures became more rigid with the import quotas andlicenses. Gradually import tariffs increased during the ISI strategy and more imported items werebrought under tariffs. Since limited trade liberalization attempts were taken place in the first half of1960s, the period from 1965 to 1970 period is considered as a partial liberalization era. During thisperiod exchange rate policy was taken as a tool to liberalize the international trade. After the partialliberalization period, a rigid trade control system was embarked during the 1970 1977 period undersocialist oriented policies with a hope of further enhancing ISI strategy. This period is considered asthe most restrictive period in the country ever had. After 1977, Sri Lanka followed serious outwardoriented economic policies. Since then, various trade restriction policies were eliminated or at leastminimized with an intention of creating a liberalized economy.

2. METHODOLOGYImpact of trade liberalization on exports and imports is assessed by comparing economic conditionprevailed before and after trade liberalization during the period from 1970 to 2011. In identifying theimpacts of trade liberalization data were collected on a specific time interval. The time period selectedis from 1970 to 2011. To identify the impacts of trade liberalization, total time period is divided intotwo sub periods of before trade liberalization i.e. (1970 to 1977) and after trade liberalization i.e.(1978 to 2011). The study is mainly based on secondary data. Annual data for exports and imports iscollected from various annual reports published by the Central Bank of Sri Lanka (CBSL). Data onreal effective exchange rate is collected from the World Bank data base. The variables identified inthe main objective of the study are tested hypothetically, and quantitative analytical methods areapplied to make accurate and reliable conclusions. The study employs simple and multiple regressiontechniques. In estimating growth rates of major variables concerned Log-lin regression model isemployed.

Specifications of Models

The study uses Log-lin model in measuring growth rate of total exports, total imports and subdivisional growth of exports and imports. Growth rate of a certain economic variable is measured byapplying simple regression technique. In measuring growth of a certain variable simple regression isrun for the log of dependent variable against time. The independent variable that is timetakes valuesof 1, 2, 3, 4etc and is stated in equation 1.

lnYt= 1+ 2t + ut (1)

where Yis the dependent variable; tis time and uis the error term. The product of 2by 100 gives thegrowth rate of the dependent variable.

In estimating effects of trade liberalization on exports and imports multiple regression models is to beemployed. In this case, exports and imports are assumed to be a function of exchange rate and tradeliberalization dummy variables. Thus, the export demand function to be estimated is:

X = 0+ 1LIBR + 2REER + ut (2)


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Where X is the volume of exports, LIBR represents trade liberalization dummy variable, REER is the

real effective exchange rate and utis the error term.

The import demand model is presented in equation 3.

M = 0+ 1LIBR + 2REER + ut (3)

Where M is the volume of imports and the rest of the variables are as previously described.

3. FINDINGS

Trade Openness Measurements

The study uses three measurements to quantify the trade openness of Sri Lanka. Those standardmeasurements to assess trade openness are ratio of total exports to gross domestic product(X/GDP),imports to gross domestic product(M/GDP) and total of exports and imports to gross domestic

products(X+M/GDP). The trade literature supports that these measurements are expected to increaseover time with trade liberalization. Behavior of three variables over the two periods in Sri Lanka,restricted economic era and liberalized economic era, are shown in figure 1.

Figure 1: Behavior of Trade Openness Measurements in Sri Lanka

2 0 0 01 9 9 21 9 8 41 9 7 61 9 6 81 9 6 0

90

80

70

60

50

40

30

20

10

Ye a r

TradeOpenness

Indicators(%)

X M G D P

M G D P

X G D P

Var i ab l e

Source: Various Central Bank Reports of Sri Lanka

Figure 1 shows the results of trade policy changes during the last five decades. During the closedeconomic period from 1960 to 1977, all trade openness indicators are showing long term fallingtrends. Particularly gap between two indicators imports to GDP and exports to GDP ratios are verysmaller during the restricted economic scenario. However, after 1977 with trade liberalization, it canbe seen a dramatic increase of those two measurements by making a considerable gap between twoindicators. With rapid increase of total imports relative to the increase of total exports has increasedthe gap between these two measurements. However, at the very beginning of trade liberalizationalthough exports to GDP and imports to GDP were dramatically increased after that those tradeopenness measurements show downward trend. As a whole, after 1977, absolute annual amounts ofexports and imports increased at an increasing rate. But relative amounts of those two variables haveshown a slightly declining trend.


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In measuring economic impacts of trade liberalization on exports and imports, mainly Log-linregression model is applied to quantify growth rates of trade variables. Firstly, to measure the impactsof trade liberalization on total exports, total imports and sub sectors of exports and imports growth,the log-linear model of regression is applied for two different policy regimes, before and after tradeliberalization.

Export Sector Performance

In estimating impacts of trade liberalization on total exports, dummy variable of trade liberalization isused with real effective exchange rate variable in multiple regression analysis. The regression resultcorrected for autocorrelation and multicollinearity is depicted in table 1. Although larger probabilityin tstatistics imply that control variable, real effective exchange rate, is not statistically significant theoverall model is statistically significant and 5 percent or higher significance level. The coefficient fortrade liberalization dummy variable is statistically significant at 5 percent significant level and revealsthat trade liberalization has positively affected on the export sector of Sri Lanka.

Table 1: Estimated Regression Coefficients for Total Exports

Parameter B Probability

(t statistic)

Probability

(F statistic)Intercept -213.83 0.4317 0.0255

Trade Liberalization 19.70 0.0088

Real Effective Exchange Rate 1.47 0.3660

R2= 0.18 DW = 1.91

Export sector shows a clear distinction during the two trade regimes, closed economic era and openeconomic era. Table 2 shows the regression results which measure growth rates of independentvariables. Each estimated regression model is having a moderate or high R2 value confirming thetrustworthiness of regression models. Individual coefficients are statistically significant at anystandard significant level (0.01, 0.05 and 0.10) and probability values for F test shows overall modelsare highly significant. The regression models are tested for autocorrelation using the Breusch-Godfrey(BG) test or LM test and are free from autocorrelation. According to Log- lin regression results, totalexport during the 1970 -1977 has grown at a rate of 12.47 percent with compared to 7.39 percentgrowth during 1978 2011 time period. In measuring growth rates of sub sectors of exports, totalagricultural export has grown at a rate of 9.57 percent during the 1970 -1977 period. However, aftertrade liberalization, agricultural export has grown with a rate of 5.44 percent during the 1978 2011period. According to slope coefficient of the regression model for industrial export explanatoryvariable, it has grown at a rate of 8.9 percent after trade liberalization.

Table 2: Performance of Exports Sector in Two Trade Regimes

Period Regression Equation R2 DWProbability(t statistic)

Probability(F statistic)

0 1

1970-1977 lnX= 5.54+.1247t 0.88 1.59 0.000 0.006 0.0061978-2011 lnX= 7.10+0.0739t 0.87 1.50 0.000 0.000 0.000

1970-1977 lnAX= 5.47+0.0957t 0.76 1.56 0.000 0.005 0.005

1978-2011 lnAX= 5.76+0.0544t 0.41 1.89 0.000 0.000 0.000

1978-2011 lnIX = 6.01 + 0.0890t 0.73 1.23 0.000 0.000 0.000

Note: X = total exports; AX = Agricultural exports and IX = Industrial exports


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Import Sector Performance

Effect of trade liberalization on imports is estimated by employing multiple regression analysis and ispresented in table 3. The estimated regression model for corrected auto correlation is statisticallysignificant at 10 percent significant level and individual coefficients are significant at 5 percentsignificant level. Trade liberalization coefficient exhibits that that trade liberalization has increasedtotal imports in Sri Lanka.

Table 3: Estimated Regression Coefficients for Total Imports

Parameter B Probability

(t statistic)

Probability

(F statistic)

Intercept -9373.030 0.0156 0.0743

Trade Liberalization 3454.554 0.0256

Real Effective Exchange Rate 88.18782 0.0190

Real Effective Exchange Rate _Sq -0.197914 0.0386

R2= 0.17 DW = 1.79

Growth rates for total imports and sub sectors for pre and post liberalization periods are shown inTable 4. Time series variables in the regression model were converted to stationary and all theregression models presented in the table have been corrected for autocorrelations. Regression resultsfor total imports for two trade regimes, closed and open economy, shows a distinct difference.According to the log-lin regression results which is employed to measure the growth rate of a variabledepicts that during the closed economic era total imports of the country has grown at a rate of 11.7percent higher rate with compared to 7.39 percent growth in post liberalization era. Regarding theconsumer goods imports, growth rate of that sector prevailed 7.1 percent before the tradeliberalization period and it has slightly decreased to 6.5 percent after the trade liberalization of thecountry. Significant difference can be seen in the intermediate goods importation. Growth rate forintermediate goods importation recorded a 30 percent rate during the closed economic period of thecountry. However, this higher growth rate has been decreased up to 7.95 percent with trade

liberalization. Investment goods importation shows an opposite pattern to consumer goods andintermediate goods importation. Although this sector recorded a lower growth rate during the 1970-1977 period, after that it recorded a relatively higher growth rate. For example, investment goodimports have grown at a 4.8 percent rate during the closed economic era and this rate increased to 7.28percent in the open economic period.

Table 4: Performance of Import Sector in Two Trade Regimes

Period Regression Equation R2 DW

Probability(t statistic)

Probability(F statistic)

0 1

1970-1977 lnM = 5.73+0.1170t 0.74 1.55 0.000 0.018 0.018

1978-2011 lnM = 7.10+0.0789t 0.87 1.50 0.000 0.000 0.000

1970-1977 lnCM = 5.21+0.0710t 0.44 1.96 0.000 0.075 0.0751978-2011 lnCM = 5.68+0.0654t 0.74 1.70 0.000 0.000 0.000

1970-1977 lnINTM = 3.66+0.3038t 0.90 1.52 0.000 0.000 0.000

1978-2011 lnINTM = 6.38+0.0795t 0.93 1.59 0.000 0.000 0.000

1970-1977 lnINVM = 4.13+0.0482t 0.49 2.29 0.000 0.080 0.080

1978-2011 lnINVM = 5.62+0.0728t 0.59 1.56 0.000 0.000 0.000

Note: M = total imports; CM = consumer goods imports; INTM = Intermediate goods imports; andINVM = investment goods imports


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4. DISCUSSION

Sri Lanka implemented trade liberalization economic policies in 1978 after following severe trade

restriction era from 1970 to 1977 period. Low performance of import substitution industries, low

economic growth rate and high unemployment level are some major reasons to move the country

towards export oriented economic policies in 1978. The results of the study on export sector found

that total exports have grown at a higher rate in the closed economic era. In 1970 Sri Lankas totalexports were US$ 339 million. This amount has increased to US$ 767 million by 1977. Open

economic era started in 1978 in the country. At that time, total exports were US$ 845 million and this

has amounted to 10,559 million by 2011. Total exports have grown at a rate of 7.39 during this

period. High performance in agricultural exports, mainly Tea, Rubber and Coconut has contributed

greatly for export performance in closed economic era. On the other hand, a major reason for slower

growth rate of exports after trade liberalization in 1978 might be the difficulty of implementing sound

macroeconomic policies for a longer period continuously due to civil unrest prevailed for nearly three

decades in the country. This may hamper economic performance of the country and ultimately making

negative impact on the performance of export sector. Besides that high growth rate of exports derived

for the closed economic era could have been partly influenced by smaller base values in that period.

Sri Lankas import sector has shown a dramatic change during the two trade regimes. Total imports

have grown at 11.7 percent and 7.89 percent in closed and open economic periods respectively.

Import substitution industrial strategy could be a main reason for the higher import growth in the 1970

-1977 period. Sri Lankas import substitution industries were highly depended on imported raw

materials and this has made for higher import growth in the country. For example, intermediate goods

imports have grown at 30 percent during the 1970-1977 period. Though total imports exhibits a higher

growth rate in closed economic era than open economic era, investment goods imports are growing at

a higher rate after trade liberalization. For example, growth rate of investment goods importation is

4.82 percent in the 1970 1977 period with compared to 7.28 percent in the 1978 2011 period.

Imports of machinery, transport equipment, building materials with implementation of massive

investment projects with open economic policies might be a main reason for the higher growth rate of

investment good imports in the country.

5. CONCLUSION

The study encompassed four decades which belong to two trade regimes, pre and post liberalization

period, in Sri Lanka. Findings of the study are on the impact of trade liberalization on exports and

imports of Sri Lanka. One of the major objectives the study is to estimate growth rates of exports and

imports during the pre and post liberalization periods. Findings of the study confirm higher growth

rates of exports and imports in the closed economic period with compared to open economic period in

Sri Lanka. The study identified that growth rates of total exports and imports during the closed

economic era are 12.47 and 11.70 respectively. The growth rates for same sectors during the open

economic era are 7.39 and 7.89 respectively. Further, another major finding of the study is that import

volume has been increased more than export volume with trade liberalization in Sri Lanka.

In sector wise growth comparisons of two trade regimes, agricultural exports has grown 9.57 percent

in closed economic era and 5.44 percent in open economic era. The study has not estimated growth

rate of industrial exports during the closed era due to limited availability of data. However, after trade


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liberalization, this sector has grown by 9 percent rate over the last three decades. Also, study found

that growth rate of intermediate goods imports is almost 30 percent and is much higher during the

closed economic era with compared to 8 percent growth in open economic era. On the other hand,

growth of investment goods import shows reverse pattern of growth rates of intermediate goods

imports. This sector has shown a higher growth rate in open economic era than closed economic era.

The growth rates for pre and post liberalization eras for investment good imports are 4.82 and 7.28

respectively. One similarity regarding import sector in two trade regimes is that consumer goods

imports growth rates show similar rate in two trade regimes. Growth rates of consumer goods imports

are 7.1 and 6.54 in pre and post liberalization periods respectively.

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Trade Liberalization in Sri Lanka: Effects on Exports and Imports