protected and that a lasting peace will prevent any disruption of operations or damage to fixed assets. However, they will need incentives to do so, and experience shows that firms are more likely to invest when in better technology and raise productivity when there is pressure on their profit margins and they realize that (apart from the promise of strong institutions, the protection of property rights and reliable infrastructure) there will be no special help forthcoming from the government. In other words, when hard budget constraints and competition, both from domestic and foreign sources, are present.<sup>13</sup> Box 6 discusses competitiveness in Sri Lanka (with more details in Annex 3), while the next section focuses on hard budget constraints for state-owned enterprises.

## **Box 6. Sri Lanka: A Survey of Constraints to Doing Business**

A scan of the recent survey-based indicators of the business climate and overall competitiveness in Sri Lanka reveals a promising outlook for the business environment provided the commitment to implement stated government policy remains strong. The main take away from the survey-based evidence is that macroeconomic policy constraints have been consistently at or near the top of the main constraints to doing business in Sri Lanka.

Sri Lanka ranks 89 out of 183 countries in the World Bank Group‘s overall ―Doing Business‖ rankings in 2012, with tax policy being long considered a major drag on private sector investment. The same result comes out when looking at recent Global Competitiveness reports. Sri Lanka ranks 62 out of 139 countries in the overall Global Competitiveness Index (GCI) 2010-11. Sri Lanka seems to be lagging in terms of _Macroeconomic environment_ , especially when it comes to Government budget balance, Government debt, and Country credit rating. _Labor market efficiency_ and _Technological readiness_ come out quite low (Sri Lanka ranks 128, 111 and 85 out of 139 countries respectively).

The emergence of internationally competitive firms in Sri Lanka will also depend importantly on the trade regime. Here too the conclusion is that it is squarely in the hands of the government to improve the trade regime. Although Sri Lanka is not an outlier, the transactions costs of trading across borders are significantly higher than in comparator countries. Bureaucratic procedures rather than infrastructureimposed or technical constraints are the major source of high transactions costs incurred by exporters and importers alike. Redundant regulations and red tape as well as outdated customs procedures that are not compatible with requirements of modern trading are impeding the participation of Sri Lankan firms in more sophisticated forms of division of labor based on production fragmentation or global value chains.

# **_c. Hardening Budget Constraints for State-owned Enterprises_**

Hardening budget constraints for state-owned or public enterprises (PEs) is important for two reasons: the first is that they can help contain the fiscal burden. Transfers from the budget

> 13 Some of the clearest evidence on the efficacy of hard budgets and competition comes from the transition countries of Central and Eastern Europe.  See Pinto, Belka and Krajewski (1993), Carlin, Fries, Schaffer and Seabright (1999) and chapter 7 of European Bank for Reconstruction and Development (1999).

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