**4 |** P a g e

programs resulted in macroeconomic disequilibria.<sup>3</sup> This return to inward-oriented policies further increased the existing cleavage in the business climate between EPZs and the rest of the economy.

The combination of heavy state involvement in micromanaging foreign trade and investment through SEZ seems to have contributed to two unusual traits of Sri Lanka’s external performance (Figure 1). First, instead of an increase in their economic significance, exports and imports of goods and services relative to the GDP—the measure of economic openness—fell from around 80 percent in 1995-2004 to less than 30 percent in 2010. Second, the share of garments in manufacturing exports remained unchanged at between 60-70 percent over the period of 30 years.

**Figure 1: Peculiarities of Sri Lanka’s external performance in 1987-2010: nominal protection, openness and the share of clothing in manufactured exports (in percent)**

<!-- Start of picture text --> % 90 50<br>80 45<br>40 Average total nominal<br>70<br>protection rate (right<br>60 35 axis in %)<br>30 Exports and imports of<br>50 G&S in GDP (%)<br>25<br>40<br>20 Exports of G&S in GDP<br>30 (%)<br>15<br>20<br>10 Share of garments in<br>10 5 manufacturing exports<br>(%)<br>0 0<br><!-- End of picture text -->

**_Left axis_** : trade in percent of GDP and share of garments in manufactured exports. **_Right axis_** : average total nominal protection rate in percent.

Sources: World Bank WDI database, UN COMTRADE database, and Pursell and Ahsan (2011).

These two unusual traits of Sri Lanka’s external performance—the declining tendency of economic openness and the persistently high share of clothing in Sri Lanka’s exports of manufactured goods—set the country apart from other developing countries. As for the openness, although statistics for many countries show contractions of foreign trade in terms of GDP, Sri Lanka stands out in two respects: the contraction spread over a long period of time; and the level of openness is close to levels attained during the import-substitution era almost forty years ago.

There is, however, another possible explanation for the falling openness—the increase in remittances. The value of remittances in 2001-2010 grew at an average rate of 16 percent and was 3.7 times larger in 3 The last bout of inflation peaked in 2008. Sri Lanka has restored macroeconomic stability or “sound money;” one of—to borrow an apt phrase from Krugman (1995, 29)—the dual “Victorian virtues” in economic policy with another being adherence to free markets. It suffered from serious macroeconomic instability in 2007-08 with government running huge budget deficits and lax monetary policy producing inflation peaking at 23 percent in 2008. Double-digit inflation rates usually spell trouble as they suppress private investment because of fears of tax increases. But as a result of deep cuts in the budget deficit made in part possible thanks to financing obtained from the IMF under the Stand-by-Arrangement, inflation rate fell dramatically to 3.5 percent in 2009 and slightly edged up to 6.4 percent in 2010. In consequence, Sri Lanka has become ‘virtuous’ again at least on this count.