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natural resource intensive products. But it suppresses businesses’ participation in more sophisticated forms of division of labor based on production fragmentation and intra-industry specialization. While the opposite, i.e., friendly business climate and liberal foreign trade regime does not automatically lead to explosive growth performance, as this also depends on physical infrastructure, size of an economy, and other factors shaping, among others, exchange rate (e.g., tourism, remittances).

A foreign trade regime should aim to offer a wide range of benefits due to improvements in productivity thanks to less-distorted allocation of resources away from sectors in which a country may not have comparative advantage to those with the potential for competitiveness and exposure of domestic businesses to greater competition. Sri Lanka’s endowment in human capital and geographical location create huge potential for tapping opportunities created by possible participation in global manufacturing supply chains, which, together with FDI inflows, was one of the key aspects of developments in the fast growing East Asian economies—Indonesia, Malaysia, and Thailand (see World Bank 1993). A liberal foreign trade regime with low transaction costs is also critical to domestic firms’ tapping opportunities offered by participation in international division of labor and global value chains. It goes without saying that liberalization of foreign trade regime alone will not produce welfare gains in the absence of decent infrastructure and business-friendly climate. Good geographical location and the availability of entrepreneurial skills are also among ingredients important for success.

Trade liberalization in Sri Lanka dates back to 1977 when a sharp devaluation was followed by a series of sweeping trade policy reforms. During the next two decades or so, Sri Lanka had a moderately free trade regime. Its ‘liberalization’ edge, however, over other countries at a similar level of economic development began disappearing as other countries set on a path of liberalization beginning in the second half of the 1980s, whereas reforms in Sri Lanka not only lost their momentum in the 1990s but also were reversed in the early 2000s. As the 2004 WTO TPR for Sri Lanka noted: “At the time of the last Trade Policy Review in 1995, and in other instances since, the Sri Lankan authorities have stated their intention to simplify the tariff structure, by moving towards a two-band system, and reducing the simple average applied MFN rate to a single digit” (WTO 2004, p. 98). Both measures would increase transparency. Neither of them had been fully implemented.<sup>16</sup> Sri Lanka’s foreign trade regime is an outlier relative to best international practice. The continuation of policy trends that started building momentum around 2002-04 will act to hinder economic growth performance in the future.

Sri Lanka arguably failed to take advantage of the Uruguay Round of multilateral trade negotiation in 1986-94 to lock-in foreign trade liberalization. The government committed itself to bind tariff lines at rates ranging from 0 percent to 75 percent for only 36.4 percent of the total. Reforms lost their momentum around 1992. Athukorala and Jayasuriya (2004, p. 4) ascribe the loss of momentum to “... unfortunate shift in policy priorities towards politically appealing investment projects, and subsequently due to the onset of the ethnic conflict.” Foreign trade policy in Sri Lanka is not transparent, overly complicated, and characterized by frequent changes contributing to an uncertain trading environment. Moreover, it has been this way for a decade or more. The 2004 Trade Policy Review (WTO 2004, p. 87) noted: “As stated by the Central Bank, inconsistency in economic policies, including in trade policies, reversing already implemented policies, postponing the implementation of policies or changing them in an ad hoc manner lead to loss of policy credibility and market confidence. Given **Sri** 16 As of December 2011, MFN tariff schedule has five rates: 0% for imports of essential goods; 2.5% for basic raw materials; 6% for semi-processed goods; 15% for intermediate products; and 28% for other finished products.