# **I. Introduction**

Sri Lanka sits at an important moment in its history. Per capita income, nearly double that of the average across South Asia, reflects the country’s rising status as a middle-income country. Sri Lanka also outperforms other South Asian and lower-middle income countries overall with respect to a range of social indicators. In the two years since the end of an armed conflict spanning three decades, the Sri Lankan economy weathered the global economic crisis with minimal downturn and has been growing at a relatively high rate since then, namely 8 percent year-on-year in the first quarter of 2011 (World Bank 2011). There has been sustained optimism for the prospect of accelerated economic growth and poverty reduction during the anticipated post-conflict years. As in many middle-income countries, much of this hope lies with the potential for the private sector to generate investment, spur productivity and generate broaderbased, more inclusive growth. It is more important than ever to identify and assess existing constraints to investment, productivity, innovation and growth in the Sri Lankan economy.

The challenge of translating the momentum from the peace dividend into sustained higher growth of 8 percent or more a year will require structural reforms aimed at promoting aggregate savings and private investment, and increasing connectedness to global knowledge (including attracting more FDI) as a vehicle for technological upgrading. Recognizing this need, the government’s development plan –the Mahinda Chintana– seeks to raise investment rates in the country from current levels of about 25 to 35 percent of GDP. Given the government’s limited fiscal space, the bulk of the increase in investment must come from the private sector. An important distinction must be made, however, between factors which will result in a one-time upward shift in investment levels and capacity utilization rates of existing physical or tangible capital, and self-sustaining ‘endogenous growth’ as a result of transformational entrepreneurship and investment by firms in intangible or knowledge assets that drive productivity and innovation in the private sector. It is the latter that will help ensure that Sri Lanka sustains its 8 percent real GDP growth target and is the focus of this paper.

Growth theory typically assumes that aggregate output is produced combining human capital with physical capital, with growth in output explained by growth in measured labor, capital and raw materials, plus a residual part unexplained by traditionally-measured tangible inputs referred to as ‘total factor productivity’ (TFP). Aggregate output typically fails to grow as fast as it could due to insufficient savings, insufficient investment in physical and human capital, and insufficient increases in TFP. A key fact of development is that differences in measured inputs typically explain less than half of the enormous differences in per capita national income (Jones and Romer 2010; Caselli 2007). Lower-income countries are less developed not only because they have less physical and human capital per worker than developed economies, but more importantly, because firms use their tangible inputs of labor, capital and raw materials less 2