Sri Lanka economic recovery gathers pace

• AFC Asia Frontier Fund Co-Fund Manager Ruchir Desai travelled to Colombo from 29 May to 2 June 2024 to meet with policymakers and the fund’s Sri Lankan portfolio companies

By Ruchir Desai

I was in Colombo one year ago in June 2023 and things then were already beginning to look better for Sri Lanka. Inflation was falling, the Central Bank had just begun its interest rate easing cycle, the currency and stock market were seeing a rebound from the bottom, and tourism was starting to pick up momentum. All the major macro indicators were showing an improvement a year ago, which made me optimistic about the outlook for Sri Lanka.

One year later, after having increased our fund allocation to Sri Lanka, the Colombo Stock Exchange Index has returned +35% in USD terms, making it one of the best-performing stock markets globally. Furthermore, inflation at less than 1% in May 2024 compared to 12% in June 2023 has allowed the Central Bank of Sri Lanka to aggressively cut its benchmark interest rates by 700 basis points since June 2023.

In my view, the Central Bank of Sri Lanka has executed its policies tremendously well since facing the macroeconomic crisis at the start of 2022. The Central Bank’s swift decision-making is one of the key reasons for Sri Lanka being able to recover its macro-economic stability.

During my previous visit, there were some green shoots of a revival in tourism, but during this visit, Colombo was bustling with tourists despite it being off-season. My hotel and the other hotels I visited in the city were crowded with both local and international visitors and had many events like conferences and weddings taking place – this certainly was not the case a year ago.

Sri Lanka’s tourism sector has seen a major revival with the first half of 2024 bringing in almost 1 million tourists which should allow the country to get to around 2 million arrivals by the end of this year, and this will be almost back to pre-pandemic levels. This will be a huge boost to foreign exchange reserves as the tourism sector should be able to generate around USD 3.5 billion in foreign exchange income in 2024.

The pick-up in economic activity was not just restricted to the hotels. I also saw a similar trend in restaurants and malls, which were crowded with customers out for a weekend of dining and shopping. The mall which I spent more time in was the One Gall Face Mall, which is part of the Shangri-La Hotel, and the mall is very modern, well laid out, and has all the major brands present.

This is the type of modern hotel/retail infrastructure Colombo needs in order to build its tourism sector. This process is taking place and began with the opening of the Shangri-La Hotel a few years ago, and just last month in May 2024, ITC Hotels from India opened its new hotel in Colombo on the waterfront, which is adjacent to the Shangri-La. The new ITC hotel has attracted much interest, with all its key restaurants being fully booked for weeks in advance. I was lucky to have lunch at the ITC’s famous Indian restaurant with pretty much all the tables fully occupied for Saturday lunch.

Though the Shangri-La and the ITC Hotel have improved the waterfront landscape in downtown Colombo, another much-awaited project is the integrated resort being developed by John Keells Holdings. This is a multi-use project which includes residential and office space, a mall, a hotel, a convention centre, and a gaming area, which will be developed by Melco Resorts from Macau (Melco).

As a result of this partnership with Melco, the integrated resort project will be named the City of Dreams Sri Lanka, in line with other Melco integrated resorts in the region, like the City of Dreams Macau and the City of Dreams Manila.

The City of Dreams Sri Lanka will be the first fully integrated resort of this scale in South Asia, and once it begins operations, it could be a big driver of tourism for Sri Lanka, given that it will have a well-known brand managing the gaming operations of which there are none of this size in the region. The fund is a shareholder in John Keells Holdings.

With all this buzz on the ground in Colombo, it does not surprise me that Sri Lanka’s 1Q24 GDP growth came in far ahead of expectations at 5.3%. With the Asian Development Bank, Central Bank of Sri Lanka, and the IMF (International Monetary Fund) projecting GDP growth rates of 2-3% in 2024, I believe this outstanding result for the first quarter should lead to an upward revision in GDP growth forecasts to factor in the increase in economic momentum as well as the continued impact of a low base from 2023.

The improvement in economic growth was also present in the sentiment in meetings with Sri Lankan companies. Almost all the companies I met in Colombo were cautiously optimistic about their future outlook, and 1Q24 results for most companies in Sri Lanka have been good, led by the banking sector, which has seen exceptional results on the back of lower provisioning costs.

The Sri Lankan government continues to carry out the hard work of the last two years, which has also resulted in the IMF passing its second review for the country on 12th June 2024, which will result in a disbursement of an additional USD 336 million from the total loan size of USD 3 billion.

Besides continuing with the IMF led reform agenda, one of the last milestones left for the country is to finalize the restructuring of its international sovereign bonds for which talks are ongoing. Whether these negotiations are finalised in the next few months or not, it does not significantly impact the ongoing economic recovery taking place in the country.

One concern that arose a few times, especially among the domestic investors, was the upcoming Presidential election scheduled for September-October 2024. An upcoming election in any country makes investors a bit nervous, but in Sri Lanka’s case, even more so because of the ongoing reforms linked to the IMF program. A concern among investors is that if a new President/party is elected, this could mean renegotiation of the IMF program. However, I doubt that this concern will play out in a significant manner.

Given the economic balance and geopolitical interests in Sri Lanka, any political party that comes to power in the upcoming election does not have room to deviate significantly from the reform path the country has taken. Any major deviation from the reform path will be extremely detrimental not only to Sri Lanka’s IMF program but also to the country’s economic and geopolitical prospects.

I therefore believe that any political rhetoric on the IMF program will likely be toned down once elections are through as the economic reality is that the economic reforms should continue and hopefully all the Sri Lankan political parties adapt to this reality.

Sri Lanka has made huge strides given the economic situation they were in just two years ago, and the country is now seeing some good economic momentum which should not be interrupted with any shortsightedness.

To put things in context, Sri Lanka has not only had a tough last two years, but it has had a challenging time since 2018, when it went through a political crisis, after which its tourism sector was negatively impacted by the Easter Sunday attack in 2019, followed by the pandemic in 2020/2021 and finally the political crisis in 2022. The country did not really get a chance to see a full recovery as there was some setback every year.

However, despite any upcoming political noise, I believe the ongoing economic momentum and stability will be maintained as Sri Lanka’s macroeconomic recovery has only begun. Sri Lanka needs to keep it simple and focus on its trade and tourism sectors while leveraging on India’s long-term economic growth, similar to how many ASEAN countries benefitted from China’s economic growth in the 2000’s.

I firmly believe that if Sri Lanka can follow through with stable economic growth of 3-4% over the next few years, investors will reward this consistency, which has been absent for the last five years, by re-rating the Colombo All Share Index further upwards given the attractive valuations of blue-chip companies, lower interest rates and the prospects for consistent earnings growth.

Our largest holdings in Sri Lanka continue to trade at very attractive valuations even though their stock prices have seen a sharp appreciation in the last two years. The fund’s largest position in Sri Lanka is Sunshine Holdings, a consumer-focused conglomerate that trades at a P/E of 5.8x its 12 months forward earnings. The fund’s second biggest position in the country is Commercial Bank of Ceylon, Sri Lanka’s largest private sector bank by assets and market capitalisation that trades at a P/B of only 0.6x.

After this visit to Colombo, we remain positive on Sri Lanka and have increased the fund’s weight to the country.

(The writer is Co-Fund Manager of AFC Asia Frontier Fund and could be reached via email at [email protected])