SOE 2006 Policy Brief - Services Liberalisation and CEPA

Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2006 Agriculture Reforms: Irrigation Water
Charges and Land Policy
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9. Liberalization of Services Sector under the India-Sri Lanka CEPA

9.1 Introduction Services encompass a wide range of activities, dominating economic activities at virtually every stage of development. The adequate provision of services is increasingly recognized as one of the preconditions for rather than a result of development. For instance, inadequate infrastructure services, such as poor telecommunications and transport networks or a weak financial system, are perceived as critical bottlenecks on sustainable development. Distribution, trade finance, insurance, marketing and other business services are complementary to a healthy growth of industrial activities. Benefits to be derived from liberalization and competition in the services sector may materialize in terms of increased trade in both goods and services, higher inward investment in the service sectors and, above all, better access to services by consumers at low prices. The services sector has been the most dynamic growth sector of the Sri Lankan economy in the recent past. The bulk of the contribution to GDP growth and employment comes from the services sector and its potential to contribute further towards improving the welfare of the population is quite significant. For example, wider access to affordable and better quality in health, education, water, sanitation, etc. has a strong bearing on improving welfare, particularly of the poor. While trade initiatives undertaken by Sri Lanka in the past have focused on liberalization of trade in goods, the liberalization of services is one of the new areas to be included in the proposed Comprehensive Economic Partnership Agreement (CEPA) being negotiated between Sri Lanka and India. The CEPA is a sequel to the 1998 India-Sri Lanka Free Trade Agreement (ISFTA), which has been in operation since March 2000. In June 2002, Sri Lanka and India agreed to expand the ISFTA to bring about greater integration of the two economies i.e., to deepen and broaden the scope of existing arrangements. This was followed by the appointment of the Joint Study Group in April 2003, which recommended the entering into of a CEPA to further liberalize trade in goods, and also extend its scope to services, investment and economic cooperation. While it may still be the case that the Sri Lankan business sector is yet to get used to the idea that India may be as much an opportunity as a threat, the decision to proceed on the CEPA is a recognition that there is still untapped potential in bilateral trade, investment and services between the
For a full version of Sri Lanka: State of the Economy 2006 and other publications of the IPS contact publications@ips.lk , or visit www.ips.lk
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Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2006 Agriculture Reforms: Irrigation Water Charges and Land Policy
two countries. Thus, discussions on the CEPA were launched in 2004 with the Commerce Secretary level meetings, which have been followed by seven rounds of technical level negotiations as of July 2006. The policy brief examines briefly the scope for liberalization of trade in services under the on-going CEPA negotiations.
Box 9.1 Making Services Work for the Poor

Services are very important to the poor. For example, services like education and health underpin human capital, which plays a major role in breaking the cycle of poverty. Similarly, services like transport, energy, financial and ICT all open profitable opportunities to the poor, from being able to bring their produce to the market in less time at lower cost (transport services), to being able to be put in touch with remote buyers and to obtain up-to-date price information (ICT). Yet, too often the poor have no access to such services, or have access to services of poor quality, while better quality services remain unaffordable. Service sector liberalization is one component of a series of complementary policies that can help to overcome this problem. By liberalizing services, the resultant increase in the level of competition between service providers leads to downward pressure on service prices, making services more affordable to the poor. However, liberalizing services has to be accompanied by complementary policies if it is to work for the poor. First, the government will have to adopt pro-poor policies such as universal service requiring new entrants to serve (or contribute to the service of) rural areas in addition to profitable urban areas. Second, there should be an effective regulatory framework to monitor the implementation of policy. Finally, the government may need to adopt innovative funding mechanisms to bridge the gap between service providers and the poor, such as output-based aid and vouchers. Across-the-board subsidies, which have been favoured so far, disproportionately benefit the non-poor and are in fact anti-poor.
9.2 Why Services Liberalization? Liberalizing the services sector refers in this context to the lowering or elimination of barriers to providing services by non-national service suppliers. To understand the nature
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of these barriers, it is useful to refer to the WTO General Agreement on Trade in Services (GATS), which classifies services into four modes of supply (Box 9.2). Barriers to trade in services basically refer to restrictions affecting any of the four modes of supply. Typical examples include, exchange control restrictions on remitting foreign currency for a service obtained abroad, restrictions on foreign ownership in banks, hospitals, schools etc., immigration restrictions on entering the country for work purposes relating to the supply of a service, and non-recognition of qualifications of foreign services suppliers for the purpose of providing a service locally.
Box 9.2 WTO GATS Modes of Supply

Mode 1 (cross-border): services that are transmitted by the service supplier to the service consumer without either having to leave their respective countries (e.g., ecommerce, international telephone calls). Mode 2 (consumption abroad): services provided through the service consumer moving to the service suppliers country (e.g., travel abroad for education, health and tourism). Mode 3 (commercial presence): services provided by a foreign services supplier through ownership of a company, branch or other legal entity in the service consumers country (e.g., services provided by foreign banks operating locally). Mode 4 (movement of natural persons): the temporary movement of persons to the service consumers country to provide a service (e.g., foreign doctors working in local hospitals, IT professionals coming to repair a computer system).
Reducing or eliminating barriers to trade in services through liberalization leads to an increase in the volume of internationally traded services, as service consumers have access to the most efficient foreign suppliers. This increase in trade benefits both the service exporting and the service importing economies. The service exporting economy is able to increase its export earnings, and possibly employment in the particular sector. The service importing economy benefits from lower cost and higher quality as a result of the increased competition. This in turn has important knock-on effects throughout the economy, as services (such as transport, electricity, telecommunications and banking and finance) are important inputs in the production of other goods and services. Thus, export industries can become more competitive, while domestic prices can be reduced, resulting
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in a lower cost of living. In addition, the supply of a service though commercial presence (mode 3) brings in needed investment and foreign exchange. However, the liberalizing country may have to face certain adjustment costs as a result of opening itself to competition from foreign services suppliers. In particular, less efficient domestic service suppliers may be forced out of business. In theory, based on assumptions of full employment and perfect factor markets, resources will be reallocated to the most efficient use, and the economy will be better off. However, given the realities in developing countries, it is more possible that, as a result of competition from more efficient foreign suppliers, workers would simply be moved from inefficient local sectors into unemployment. Therefore, adjustment costs may be significant and long-term. As a result, liberalization should be approached cautiously. In addition, liberalization has to be accompanied by an effective regulatory framework, to ensure that the services of foreign services suppliers meet the requisite standards of quality, skill and care. For example, there should be licensing and registration requirements for foreign professionals like doctors and engineers wishing to start up a practice in the territory. The regulatory framework should also include provisions to minimize the emergence of two-tier services, such as high quality, expensive services for the rich and low quality, cheap services for the poor. 9.3 Services Profiles of Sri Lanka and India The services sector is the dominant sector in both India and Sri Lanka, and the driving force of recent economic growth in both economies. In addition, both economies also are heavily reliant on trade in services. In Sri Lanka, the services share of GDP was 55.8 per cent in 2004.1 The services sector grew at 7.6 per cent, exceeding the years GDP growth rate of 5.4 per cent. Growth in the sector was driven by sustained strong growth in telecommunications (31 per cent), followed by cargo handling at the port, hotels and restaurants, and import and export trade. In India, the services sector composition of GDP in 2004-05 was 57.6 per cent, and the sectors growth rate was 8.6 per cent, compared to the average GDP growth rate of 7.5
1
2005 figures have not been used for the comparison because they have been skewed by the effects of the 26 December 2004 tsunami.
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per cent over the last five years. The main drivers of services sector growth in India were the trade, hotels, transport and communication sectors, which together contributed almost 60 per cent of the sectors growth in 2004-5. The software sector has grown exponentially, with total revenues (domestic revenues and exports) growing by 32 per cent to reach US$ 22 billion in 2004-05, amounting to 3 per cent of GDP. Both India and Sri Lanka rely heavily on services exports and imports as defined in Box 9.2. Sri Lankas main services exports are the services of migrant workers (mode 4 in the GATS classification), tourism (mode 2 of t0he GATS), transportation services (passenger fares, freight charges and port related earnings) (encompassing modes 1 and 2 of the GATS), telecommunication services and IT (mode 1 of the GATS). Sri Lankas main services imports are transportation services, other business services and travel. Indias main service exports are software services (including IT-enabled services (ITES) and business process outsourcing (BPO)) (GATS mode 1), transportation, tourism and remittances of migrant Indians. Indias main service imports are business and professional services (including construction, financial, communication and managerial services), reflecting the ongoing technological transformation and modernisation of the economy, and travel, of which business travel accounted for about 60 per cent. Both countries are overall net exporters of services (Table 9.1). The surplus in the services and transfers accounts of the balance of payments (BOP) account has helped to offset the widening deficits in the trade account in both countries in recent years.
Table 9.1 Selected Services Exports and Imports of India and Sri Lanka (US$ mn.)
Item Travel, net Exports Imports Transportation, net Exports Imports Computer and information services, net Total non-factor services, net (1) Worker remittances, net (2) India -497 5,029 5,526 509 5,048 4,539 17,200 14,630 20,459 Sri Lanka 217 513 296 209 624 415 72 419 1,350
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Total of (1) + (2) Trade account balance

Notes:
35,089 -38,130
1,769 -2,243
Figures for India are for 2004-05 and for Sri Lanka for 2004.
Source: Central Bank of Sri Lanka, Annual Report 2004; and, Reserve Bank of India, Annual Report 2004-05.
9.4 The Liberalization of Services under CEPA The liberalization of services under CEPA takes place against the backdrop of the two countries existing level of service sector liberalization, and commitments given to the WTO. Beginning with the existing level of services liberalization, Sri Lanka has unilaterally liberalized modes 1 and 2 under the Exchange Control Act. Sri Lanka maintains a very liberal regime for mode 3, and foreign ownership up to 100 per cent of equity is automatically allowed in most services sectors, including key sectors like banking and insurance, as a result of progressive liberalization since the early 1990s. However, mode 4 is not open yet. Movement under this mode requires case-by-case approval by the relevant line ministry or authority (for example, the Ministry of Health has to give its recommendation before a foreign doctor may be issued with a work permit). India has also made substantial achievements in unilaterally liberalizing its services sector since embarking on economic reforms in 1991/92. Yet, India has not progressed as far as Sri Lanka. Modes 1 and 2 have been liberalized, but are subject to limits prescribed by the Reserve Bank of India. Similarly, while foreign direct investment is allowed up to 100 per cent, without prior approval, in many service sectors (mode 3), key area like banking and insurance are still restricted. As in the case of Sri Lanka, India has not liberalised mode 4. Second, as WTO members, India and Sri Lanka have given undertakings (called commitments) under the GATS as to minimum levels of openness in certain sectors. These commitments extend to all WTO members. Although India has committed more service sectors in the WTO than Sri Lanka,2 Sri Lanka is more open based on the extensive unilateral liberalization referred to above. Therefore, under the CEPA, Sri Lanka can gain in the nature of market access to India. However, domestic capabilities
2
India has taken commitments in ten service sectors, while Sri Lanka has in three tourism, telecommunications and financial services.
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may need to be further developed before being able to take advantage of market access to India. In addition, Sri Lankan service suppliers should be interested in accessing the Indian market. Hitherto, most Sri Lankan professionals, for example, have focused mainly on providing services in relation to developed country markets. The liberalization of services under CEPA is predicated on the recognition of three principles, as in the case of the ISFTA the asymmetry of the economies, progressive liberalization and sequencing of liberalization. This means that, while both countries will take a gradualist approach to liberalization, Sri Lanka will be entitled to open up less than India at the beginning. In addition, CEPA follows the GATS approach of request-offer negotiations and positive listing of services sectors. This means only those sectors specifically listed by a country will be liberalized. In addition, a country may specify further restrictions, or limitations, on liberalization in the sectors it has listed.3 Such limitations can effectively address concerns that the CEPA would result in the floodgates being opened. Under CEPA, for those sectors that have already been liberalized unilaterally, Sri Lanka may bind itself to preserve the existing level of liberalization to India compared to the present option of reversing unilateral liberalization at any time. Alternatively, Sri Lanka may bind itself to a lower level of openness than that presently applied. Either way, giving an undertaking under CEPA provides an assurance of a minimum level of market opening, which provides a measure of certainty to would-be service suppliers. However, for those sectors already bound in the WTO, liberalization under CEPA will have to offer something beyond what is offered to all other WTO members. This could be undertaking commitments in new sectors, or increasing the level of commitments in sectors opened in the WTO. The same would apply, in return, to India. Indian requests to Sri Lanka relate, among others, to liberalisation of financial services, professional services, computer services, construction services, other business services, tourism and travel related services and maritime transport services. In most of these
3
In the GATS methodology, this is by listing specific limitations on market access and national treatment in the countrys schedule. Market access denotes the terms on which trade in services under any of the four modes of supply is permitted to take place, while national treatment denotes treating foreign service suppliers not less favourably than their national counterparts.
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sectors, Sri Lanka has already fully liberalized unilaterally, with the notable exception of mode 4. Sri Lankas main requests to India relate to liberalization of air services,4 financial services, maritime transport services, retail services and tourism. In many of these sectors, Sri Lankan service suppliers have faced barriers to access the Indian market. 9.5 Conclusion What does liberalization of services under CEPA bode for the Sri Lankan economy, service consumers and service suppliers? For Sri Lankan service consumers, there is an outright benefit better service, better value for money and increased choice as a result of more competition. For Sri Lankas service suppliers, liberalization represents both challenges and opportunities. The pressure of competition in hitherto protected sectors would force domestic service suppliers to become more efficient, and more responsive to consumer needs. Furthermore, by following the approach of progressive and sequential liberalization (which, as mentioned previously is recognised by CEPA), the costs of dislocation can be minimized. On the other hand, apart from the pressures of competition, the infusion of Indian talent and investment can be the basis of technology transfer, which will in turn help to invigorate the local services sector. Finally, with Sri Lankas longer experience with competition from foreign services suppliers as a result of unilateral liberalization, Sri Lanka has a potential competitive advantage vis-a-vis India in a number of sectors. By removing existing restrictions in the way of Sri Lankan service suppliers, CEPA offers the opportunity to gain preferential market access to the huge and rapidly growing Indian services market. As a result of the above effects, CEPA would have a positive impact on the domestic economy as a whole. However, a proper domestic regulatory framework is an important prerequisite for realizing many of these benefits.
In the WTO, except for the limited areas of aircraft repair and maintenance services, selling and marketing of air transport services and computer reservation system services, air services were excluded from the scope of the GATS. However, Sri Lanka prefers to bring air services under the CEPA, as India and Singapore had done in their 2005 Comprehensive Economic Cooperation Agreement (CECA).
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Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2006 Agriculture Reforms: Irrigation Water

Charges and Land Policy

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9. Liberalization of Services Sector under the India-Sri Lanka CEPA

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Box 9.1 Making Services Work for the Poor

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Box 9.2 WTO GATS Modes of Supply

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Total of (1) + (2) Trade account balance

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