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SriLankanJournalofBankingandFinance(SLJBF),Vol.01,No.

01,2013,ISSN2349271

37

TRADE LIBERALIZATION IN SRI LANKA: EFFECTS ON EXPORTS AND


IMPORTS
Herath H.M.S.P.
1
, Cao Liang
2
, Cheng Yongbing
3

1
PhD Candidate
School of Business Administration
Zhongnan University of Economics and Law, Wuhan - P.R. China
E mail: shan_wayamba@yahoo.com


2
Professor
School of Business Administration, Zhongnan University of Economics and Law
Wuhan - P.R. China
E- mail: frankcao@126.com

3
Associate Professor
School of Business Administration, Zhongnan University of Economics and Law
Wuhan - P.R. China
E-mail: yongbingchen@163.com

ABSTRACT
This paper examines the process of Sri Lankas trade liberalization and its impact on exports and
imports. Secondary data is used to estimate effects of trade liberalization on exports and imports for
the period from 1970 to 2011. In estimating impacts of trade liberalization on export and import
sectors, total time period is divided into two sub periods of before trade liberalization i.e. (1970
1977) and after trade liberalization i.e. (1977 2011). The study mainly employs simple and multiple
regression models to disentangle trade effects. The main empirical results suggest that growth rate of
total exports and imports are higher during the closed economic period than in the open economic
period.
Key Words: Trade Liberalization, Exports, Imports

1. INTRODUCTION

The movement toward free trade by reducing tariff and non-tariff trade barriers is a major driving
force in most economies of the world to achieve higher economic performance. Sri Lanka started to
open the economy in 1978 after following import substitution industrial (ISI) policies prior to 1977
with the expectation of rapid development of the country. Export expansion is one of the major
objectives of trade liberalization policies of Sri Lanka. With expectation of export led growth, policy
makers have eliminated various trade restrictions after 1977. Especially reduction and simplification
of tariffs, quantitative restrictions and exchange rate policies are the major tools in moving to free
trade. First, Sri Lanka moved to managed floating exchange rate system from fixed exchange rate
system in 1978. Moving to managed floating exchange rate system, the country expected expansion of
exports and contraction of imports with depreciation of the domestic currency. Another important
policy implemented to liberalize the trade of Sri Lanka was the simplification and rationalization of
tariff structure of the country. However, expected results on export and import sectors of moving the
country for free trade has become irregular during the last three decades. Policy makers need to know
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the answers to several questions. First, what is the effect of trade liberalization on overall exports and
imports of the country? Second, what impact does trade liberalization creates on the composition of
exports and imports? Third has trade liberalization influenced on direction of trade of the country? In
this context, the main objective of the study which is to extricate the effect of trade liberalization on
export and import of Sri Lanka is of great importance to analyze and would be more beneficial for the
future trade reforms of the country.

In international trade literature, two broad categories of empirical studies prevail on trade
liberalization, exports and economic performance. First category include empirical studies of large
multi country studies which examine the processes of trade policy reform within individual countries,
and its consequences in detail (e.g. Little, Scitovsky and Scott, 1970; Balassa, 1978; Krueger, 1971;
Bhagwati, 1978; and Michaely et al. 1991). Second category consists of econometric studies which
use time series analysis, cross-section analysis, or panel data analysis (Santos and Paulino, 2002;
Leamer, 1988; Edwards, 1998).

Research on identifying specific relationship between trade liberalization and export growth gives
mixed results. Some studies confirm that countries which embarked on liberalization programs have
improved their export performance e.g. India (Joshi and Little, 1996); Latin American countries
(Bleaney, 1999), and Bangladesh (Ahmed, 2000). Other studies have found only a weak relationship
(e.g. Agosin, 1991; Clarke and Kirkpatrick, 1992; Greenaway and Sapsford, 1994; Shafaedin, 1994,
and Jenkins, 1996). The most interesting and comprehensive recent study is that by Santos-Paulino
(2002) who takes a panel of twenty-two developing countries that undertook significant trade
liberalization during the period 1972-97. Trade liberalization is measured by the ratio of export
duties (as a measure of the tax on exports), and by a dummy variable which takes the value of one in
the year when significant liberalization took place (and thereafter) and zero otherwise. Panel data
estimation techniques are then applied to the determination of export growth in these twenty-two
countries over the period of analysis, using as independent variables the real exchange rate, the
growth of world income, and the measures of liberalization. Depending on the equation specification,
the central estimate is that trade liberalization has raised export growth by one to two percentage
point. Also it is interesting to note that the income elasticity of demand for exports always dominates
the price elasticity. Whereas the income elasticity of exports averages about 1.5, the price elasticity is
not higher than 0.16. In these circumstances, currency devaluation would not improve export
earnings from the demand side.

Trade liberalization of an economy doesnt exactly imply faster export growth of the country but in
practice the two variables appear to be highly correlated. The impact of trade liberalization on
economic growth probably works mainly through improving efficiency and stimulating exports which
have powerful effects on both supply and demand within an economy (Thirlwall, 2002). In studying
effect of trade liberalization on exports and imports, Lopez (2005) has carried out a study in Mexico
to disentangle the effect of trade liberalization. Researcher found that Mexicos trade liberalization
has positively affected on the performance of exports and imports by a similar magnitudes. However,
he found Mexicos imports have responded earlier than its exports. Also, the study concludes that
discriminatory trade liberalization policies with North American Free Trade Agreement (NAFTA) has
not significantly affected on exports. But there is a significant effect on import growth.

Overview of trade policy reforms

After gaining independence in 1948 from British Colonialists, economic policies of Sri Lanka have
changed time to time with changes in political environment and some external shocks. Since 1948, the
governments which were in power have implemented inward-looking economic policies and out-ward
looking economic policies time to time. During the 1948 1955 period, Sri Lanka experienced free
trade era. Favorable balance of payment condition appeared due to Korean War boom in 1951/52 and
tea boom in 1954/55 was the major reason that leads Sri Lanka for liberalized trade policies (CBSL,
1998). However this favorable balance of payment situation was not continued until the end of 1950s
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and country marked the beginning of closed economy in 1956. As a result of deterioration of balance
of payment situation and some political changes, the country began import substitution industrial
strategy (ISI) in 1956.

From 1956 to 1965, the government which were in office implemented ISI strategy to overcome
balance of payment difficulties and to achieve self sufficiency in rice and other essential agricultural
goods. During this period the restrictive measures became more rigid with the import quotas and
licenses. Gradually import tariffs increased during the ISI strategy and more imported items were
brought under tariffs. Since limited trade liberalization attempts were taken place in the first half of
1960s, the period from 1965 to 1970 period is considered as a partial liberalization era. During this
period exchange rate policy was taken as a tool to liberalize the international trade. After the partial
liberalization period, a rigid trade control system was embarked during the 1970 1977 period under
socialist oriented policies with a hope of further enhancing ISI strategy. This period is considered as
the most restrictive period in the country ever had. After 1977, Sri Lanka followed serious outward
oriented economic policies. Since then, various trade restriction policies were eliminated or at least
minimized with an intention of creating a liberalized economy.

2. METHODOLOGY

Impact of trade liberalization on exports and imports is assessed by comparing economic condition
prevailed before and after trade liberalization during the period from 1970 to 2011. In identifying the
impacts of trade liberalization data were collected on a specific time interval. The time period selected
is from 1970 to 2011. To identify the impacts of trade liberalization, total time period is divided into
two sub periods of before trade liberalization i.e. (1970 to 1977) and after trade liberalization i.e.
(1978 to 2011). The study is mainly based on secondary data. Annual data for exports and imports is
collected from various annual reports published by the Central Bank of Sri Lanka (CBSL). Data on
real effective exchange rate is collected from the World Bank data base. The variables identified in
the main objective of the study are tested hypothetically, and quantitative analytical methods are
applied to make accurate and reliable conclusions. The study employs simple and multiple regression
techniques. In estimating growth rates of major variables concerned Log-lin regression model is
employed.

Specifications of Models

The study uses Log-lin model in measuring growth rate of total exports, total imports and sub
divisional growth of exports and imports. Growth rate of a certain economic variable is measured by
applying simple regression technique. In measuring growth of a certain variable simple regression is
run for the log of dependent variable against time. The independent variable that is time takes values
of 1, 2, 3, 4etc and is stated in equation 1.

lnY
t
=
1
+
2
t + u
t
(1)

where Y is the dependent variable; t is time and u is the error term. The product of
2
by 100 gives the
growth rate of the dependent variable.
In estimating effects of trade liberalization on exports and imports multiple regression models is to be
employed. In this case, exports and imports are assumed to be a function of exchange rate and trade
liberalization dummy variables. Thus, the export demand function to be estimated is:

X =
0
+
1
LIBR +
2
REER + u
t
(2)

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Where X is the volume of exports, LIBR represents trade liberalization dummy variable, REER is the
real effective exchange rate and u
t
is the error term.

The import demand model is presented in equation 3.

M =
0
+
1
LIBR +
2
REER + u
t
(3)

Where M is the volume of imports and the rest of the variables are as previously described.

3. FINDINGS
Trade Openness Measurements
The study uses three measurements to quantify the trade openness of Sri Lanka. Those standard
measurements to assess trade openness are ratio of total exports to gross domestic product(X/GDP),
imports to gross domestic product(M/GDP) and total of exports and imports to gross domestic
products(X+M/GDP). The trade literature supports that these measurements are expected to increase
over time with trade liberalization. Behavior of three variables over the two periods in Sri Lanka,
restricted economic era and liberalized economic era, are shown in figure 1.
Figure 1: Behavior of Trade Openness Measurements in Sri Lanka
2 0 0 0 1 9 9 2 1 9 8 4 1 9 7 6 1 9 6 8 1 9 6 0
9 0
8 0
7 0
6 0
5 0
4 0
3 0
2 0
1 0
Year
T
r
a
d
e

O
p
e
n
n
e
s
s

I
n
d
i
c
a
t
o
r
s

(
%
)
XM GDP
M GDP
XG DP
Vari ab l e

Source: Various Central Bank Reports of Sri Lanka
Figure 1 shows the results of trade policy changes during the last five decades. During the closed
economic period from 1960 to 1977, all trade openness indicators are showing long term falling
trends. Particularly gap between two indicators imports to GDP and exports to GDP ratios are very
smaller during the restricted economic scenario. However, after 1977 with trade liberalization, it can
be seen a dramatic increase of those two measurements by making a considerable gap between two
indicators. With rapid increase of total imports relative to the increase of total exports has increased
the gap between these two measurements. However, at the very beginning of trade liberalization
although exports to GDP and imports to GDP were dramatically increased after that those trade
openness measurements show downward trend. As a whole, after 1977, absolute annual amounts of
exports and imports increased at an increasing rate. But relative amounts of those two variables have
shown a slightly declining trend.

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In measuring economic impacts of trade liberalization on exports and imports, mainly Log-lin
regression model is applied to quantify growth rates of trade variables. Firstly, to measure the impacts
of trade liberalization on total exports, total imports and sub sectors of exports and imports growth,
the log-linear model of regression is applied for two different policy regimes, before and after trade
liberalization.
Export Sector Performance
In estimating impacts of trade liberalization on total exports, dummy variable of trade liberalization is
used with real effective exchange rate variable in multiple regression analysis. The regression result
corrected for autocorrelation and multicollinearity is depicted in table 1. Although larger probability
in t statistics imply that control variable, real effective exchange rate, is not statistically significant the
overall model is statistically significant and 5 percent or higher significance level. The coefficient for
trade liberalization dummy variable is statistically significant at 5 percent significant level and reveals
that trade liberalization has positively affected on the export sector of Sri Lanka.

Table 1: Estimated Regression Coefficients for Total Exports
Parameter B Probability
(t statistic)
Probability
(F statistic)
Intercept -213.83 0.4317 0.0255
Trade Liberalization 19.70 0.0088
Real Effective Exchange Rate 1.47 0.3660
R
2
= 0.18 DW = 1.91

Export sector shows a clear distinction during the two trade regimes, closed economic era and open
economic era. Table 2 shows the regression results which measure growth rates of independent
variables. Each estimated regression model is having a moderate or high R
2
value confirming the
trustworthiness of regression models. Individual coefficients are statistically significant at any
standard significant level (0.01, 0.05 and 0.10) and probability values for F test shows overall models
are highly significant. The regression models are tested for autocorrelation using the Breusch-Godfrey
(BG) test or LM test and are free from autocorrelation. According to Log- lin regression results, total
export during the 1970 -1977 has grown at a rate of 12.47 percent with compared to 7.39 percent
growth during 1978 2011 time period. In measuring growth rates of sub sectors of exports, total
agricultural export has grown at a rate of 9.57 percent during the 1970 -1977 period. However, after
trade liberalization, agricultural export has grown with a rate of 5.44 percent during the 1978 2011
period. According to slope coefficient of the regression model for industrial export explanatory
variable, it has grown at a rate of 8.9 percent after trade liberalization.

Table 2: Performance of Exports Sector in Two Trade Regimes
Period Regression Equation R
2
DW
Probability
(t statistic)
Probability
(F statistic)

0

1

1970-1977 lnX= 5.54+.1247t 0.88 1.59 0.000 0.006 0.006
1978-2011 lnX= 7.10+0.0739t 0.87 1.50 0.000 0.000 0.000
1970-1977 lnAX= 5.47+0.0957t 0.76 1.56 0.000 0.005 0.005
1978-2011 lnAX= 5.76+0.0544t 0.41 1.89 0.000 0.000 0.000
1978-2011 lnIX = 6.01 + 0.0890t 0.73 1.23 0.000 0.000 0.000

Note: X = total exports; AX = Agricultural exports and IX = Industrial exports

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Import Sector Performance


Effect of trade liberalization on imports is estimated by employing multiple regression analysis and is
presented in table 3. The estimated regression model for corrected auto correlation is statistically
significant at 10 percent significant level and individual coefficients are significant at 5 percent
significant level. Trade liberalization coefficient exhibits that that trade liberalization has increased
total imports in Sri Lanka.

Table 3: Estimated Regression Coefficients for Total Imports
Parameter B Probability
(t statistic)
Probability
(F statistic)
Intercept -9373.030 0.0156 0.0743
Trade Liberalization 3454.554 0.0256
Real Effective Exchange Rate 88.18782 0.0190
Real Effective Exchange Rate _Sq -0.197914 0.0386
R
2
= 0.17 DW = 1.79

Growth rates for total imports and sub sectors for pre and post liberalization periods are shown in
Table 4. Time series variables in the regression model were converted to stationary and all the
regression models presented in the table have been corrected for autocorrelations. Regression results
for total imports for two trade regimes, closed and open economy, shows a distinct difference.
According to the log-lin regression results which is employed to measure the growth rate of a variable
depicts that during the closed economic era total imports of the country has grown at a rate of 11.7
percent higher rate with compared to 7.39 percent growth in post liberalization era. Regarding the
consumer goods imports, growth rate of that sector prevailed 7.1 percent before the trade
liberalization period and it has slightly decreased to 6.5 percent after the trade liberalization of the
country. Significant difference can be seen in the intermediate goods importation. Growth rate for
intermediate goods importation recorded a 30 percent rate during the closed economic period of the
country. However, this higher growth rate has been decreased up to 7.95 percent with trade
liberalization. Investment goods importation shows an opposite pattern to consumer goods and
intermediate goods importation. Although this sector recorded a lower growth rate during the 1970-
1977 period, after that it recorded a relatively higher growth rate. For example, investment good
imports have grown at a 4.8 percent rate during the closed economic era and this rate increased to 7.28
percent in the open economic period.
Table 4: Performance of Import Sector in Two Trade Regimes
Period Regression Equation R
2
DW
Probability
(t statistic)
Probability
(F statistic)

0

1

1970-1977 lnM = 5.73+0.1170t 0.74 1.55 0.000 0.018 0.018
1978-2011 lnM = 7.10+0.0789t 0.87 1.50 0.000 0.000 0.000
1970-1977 lnCM = 5.21+0.0710t 0.44 1.96 0.000 0.075 0.075
1978-2011 lnCM = 5.68+0.0654t 0.74 1.70 0.000 0.000 0.000
1970-1977 lnINTM = 3.66+0.3038t 0.90 1.52 0.000 0.000 0.000
1978-2011 lnINTM = 6.38+0.0795t 0.93 1.59 0.000 0.000 0.000
1970-1977 lnINVM = 4.13+0.0482t 0.49 2.29 0.000 0.080 0.080
1978-2011 lnINVM = 5.62+0.0728t 0.59 1.56 0.000 0.000 0.000

Note: M = total imports; CM = consumer goods imports; INTM = Intermediate goods imports; and
INVM = investment goods imports
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4. DISCUSSION
Sri Lanka implemented trade liberalization economic policies in 1978 after following severe trade
restriction era from 1970 to 1977 period. Low performance of import substitution industries, low
economic growth rate and high unemployment level are some major reasons to move the country
towards export oriented economic policies in 1978. The results of the study on export sector found
that total exports have grown at a higher rate in the closed economic era. In 1970 Sri Lankas total
exports were US$ 339 million. This amount has increased to US$ 767 million by 1977. Open
economic era started in 1978 in the country. At that time, total exports were US$ 845 million and this
has amounted to 10,559 million by 2011. Total exports have grown at a rate of 7.39 during this
period. High performance in agricultural exports, mainly Tea, Rubber and Coconut has contributed
greatly for export performance in closed economic era. On the other hand, a major reason for slower
growth rate of exports after trade liberalization in 1978 might be the difficulty of implementing sound
macroeconomic policies for a longer period continuously due to civil unrest prevailed for nearly three
decades in the country. This may hamper economic performance of the country and ultimately making
negative impact on the performance of export sector. Besides that high growth rate of exports derived
for the closed economic era could have been partly influenced by smaller base values in that period.

Sri Lankas import sector has shown a dramatic change during the two trade regimes. Total imports
have grown at 11.7 percent and 7.89 percent in closed and open economic periods respectively.
Import substitution industrial strategy could be a main reason for the higher import growth in the 1970
-1977 period. Sri Lankas import substitution industries were highly depended on imported raw
materials and this has made for higher import growth in the country. For example, intermediate goods
imports have grown at 30 percent during the 1970-1977 period. Though total imports exhibits a higher
growth rate in closed economic era than open economic era, investment goods imports are growing at
a higher rate after trade liberalization. For example, growth rate of investment goods importation is
4.82 percent in the 1970 1977 period with compared to 7.28 percent in the 1978 2011 period.
Imports of machinery, transport equipment, building materials with implementation of massive
investment projects with open economic policies might be a main reason for the higher growth rate of
investment good imports in the country.

5. CONCLUSION
The study encompassed four decades which belong to two trade regimes, pre and post liberalization
period, in Sri Lanka. Findings of the study are on the impact of trade liberalization on exports and
imports of Sri Lanka. One of the major objectives the study is to estimate growth rates of exports and
imports during the pre and post liberalization periods. Findings of the study confirm higher growth
rates of exports and imports in the closed economic period with compared to open economic period in
Sri Lanka. The study identified that growth rates of total exports and imports during the closed
economic era are 12.47 and 11.70 respectively. The growth rates for same sectors during the open
economic era are 7.39 and 7.89 respectively. Further, another major finding of the study is that import
volume has been increased more than export volume with trade liberalization in Sri Lanka.

In sector wise growth comparisons of two trade regimes, agricultural exports has grown 9.57 percent
in closed economic era and 5.44 percent in open economic era. The study has not estimated growth
rate of industrial exports during the closed era due to limited availability of data. However, after trade
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liberalization, this sector has grown by 9 percent rate over the last three decades. Also, study found
that growth rate of intermediate goods imports is almost 30 percent and is much higher during the
closed economic era with compared to 8 percent growth in open economic era. On the other hand,
growth of investment goods import shows reverse pattern of growth rates of intermediate goods
imports. This sector has shown a higher growth rate in open economic era than closed economic era.
The growth rates for pre and post liberalization eras for investment good imports are 4.82 and 7.28
respectively. One similarity regarding import sector in two trade regimes is that consumer goods
imports growth rates show similar rate in two trade regimes. Growth rates of consumer goods imports
are 7.1 and 6.54 in pre and post liberalization periods respectively.

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