Sri Lanka – Asia’s emerging investment destination

 State Minister of Finance Shehan Semasinghe 

Following are excerpts from State Minister of Finance Shehan Semasinghe’s keynote at the Daily FT-SLID and the International Chamber of Commerce Sri Lanka together with Colombo MBA Association, ACCA, CA Sri Lanka and CIMA webinar titled ‘Sri Lanka – Asia’s emerging investment destination’ on Saturday.

Background

The last 18 months have been the most challenging economic period in Sri Lanka’s post-independence history. Following a series of exogenous shocks such as the COVID-19 pandemic and the Russia-Ukraine conflict, coupled with some domestic policy missteps, Sri Lanka’s economy faced unprecedented turmoil in 2022. 

Subsequent to successive credit rating downgrades resulting in the loss of capital market access, the country eventually ran out of reserves by April 2022, forcing the sovereign to declare a unilateral moratorium on external debt repayments pending debt restructuring. 

Fast forward to August 2023, and Sri Lanka’s narrative has taken a rather dramatic turn. Inflation has declined to single digits, reaching 4.6%, foreign exchange liquidity has improved allowing regular supply of essential imports. Interest rates have declined sharply, with the one year Treasury bill yield dropping to 14% from over 30% in 2022.

Whilst there remains a long way to go, today Sri Lanka has the chance of becoming the poster child for recovery from a sovereign debt crisis. This sets up an enticing opportunity for investors to obtain first mover advantage in a market that is primed for a sustained, high quality growth over the medium to long term.

Key reforms

Sri Lanka’s recovery thus far has been underpinned by a focus on deep economic reform, addressing the core structural vulnerabilities in the economy.

Fiscal weakness has been the primary driver of macroeconomic volatility in Sri Lanka. Persistent budget deficits due to weak Government revenue generation, contributed to public debt reaching unsustainable levels. To address this the Government implemented major tax reform that enhanced tax rates in a progressive manner, yielding a 37% growth in tax revenue in the first four months of this year. 

Along with stringent management of expenditure, the revenue enhancement has enabled a small primary surplus in the first quarter of 2023, outperforming an IMF target for that quarter. This is a remarkable improvement from a primary deficit of 5.7% of GDP in 2021. Sri Lanka intends to continue its fiscal consolidation program until a primary surplus of 2.3% of GDP is achieved from 2025 onwards.

The Government intends to lock in these fiscal gains by bringing in legislation in the form of a Public Finance Management Act by end of the year or by early 2024, which will introduce robust fiscal rules and disciplines on fiscal transparency and public finance governance.

Another key source of past macroeconomic instability has been monetary accommodation of fiscal largesse. The Central Bank has consistently provided direct funding to the Government, allowing fiscal authorities the space to over-extend the budget. A new Central Bank Act that establishes greater monetary authority independence was passed in July. This act prohibits monetary financing of the budget except under exceptional circumstances – a key reform to establish macroeconomic discipline and provide the legislative framework for inflation targeting. 

Sri Lanka is also addressing long neglected vulnerabilities in State owned enterprises. Cost reflective pricing was introduced in fuel and in electricity. With competition being introduced in petroleum retail and unbundling of the electricity monopoly, the gains are expected to be locked in over the long term.

The Government is in the process of restructuring other state owned enterprises including, divestment of certain entities including Sri Lankan Airlines and Government owned shares in a number of sectors including, telecommunications, insurance, and leisure among others. 

This is just a flavour of the extensive macroeconomic reform programme that the Government has embarked upon over the last 15 months or so. Whilst such reforms have faced public opposition in the past – in a post crisis environment there has been greater public understanding of the necessity of these reforms and the need to break from bad practices of the past.

In March 2023 the International Monetary Fund provided formal endorsement for an Extended Fund Facility supporting the Government’s reform programme, marking another key milestone in Sri Lanka’s recovery efforts. This unlocked financing from other multilateral players including the World Bank and the Asian Development Bank, boosting Sri Lanka’s reserves and external stability.

Debt restructuring  

The next step on this journey to sustainable recovery is for Sri Lanka to finalise the restructuring of its debt. This would be a crucial requirement for the country to be able to restore its external credit ratings and regain access to global capital markets, providing greater stability to external balances. 

Since staff level agreement was reached with the IMF in September 2022 Sri Lanka has proactively engaged with both official and private creditors. By March 2023 all creditors provided financing assurances, making commitments to participate in restructuring Sri Lanka’s debt in line with IMF parameters. India was the first creditor to provide financing assurances – paving the way for the Paris Club and China to follow.

Thus far, steady progress has been made with continued engagement with Sri Lanka’s official creditor committee, co-chaired by India, Japan, and France which was launched this April at the IMF spring meetings in Washington DC.

Whilst China is a major creditor, it remains outside the official committee but participates as an observer. China has continuously engaged with Sri Lanka on discussions regarding debt restructuring and has committed to cooperate with Sri Lanka in seeking a speedy debt resolution. 

The Government, supported by its debt advisors Lazard and Clifford Chance, have also made progress in discussions with private bond holders, following a series of engagements to share data and discuss potential debt treatments. 

In addition to efforts to restructure foreign debt, the Government has also initiated a domestic debt optimisation programme, with a view to share burden of debt reduction, in a manner that achieves the required debt targets, without undermining stability of the domestic financial sector. 

The approved DDO by the Parliament has been well-received in the domestic capital market and has been one of the key drivers of the sharp reduction in interest rates experienced during the last month.

Sri Lanka intends to conclude its debt restructuring process during the final quarter of 2023, in line with the IMF’s first review which is due in September this year. A successful first review would place Sri Lanka in a prime position to shift from stabilisation to growth from 2024 onwards.

From stability to growth

A key lesson from Sri Lanka’s past experience is that, quality of growth matters as much, if not more than the magnitude of growth. Sri Lanka’s post-war growth was debt financed and driven largely by non-tradable sectors – sectors such as construction, domestic trade, transport, and financial services, contributed to most of the expansion of GDP in this period. 

Going forward, the Government intends to position Sri Lanka to grow through non-debt creating inflows – exports of goods and services, FDI, tourism and so on. This will provide a healthier external balance and enable Sri Lanka to service its external liabilities. 

Towards this end the Government has taken steps to resume negotiations on free trade agreements with key bilateral partners. To begin with, Sri Lanka will focus on discussions with India, China, and Thailand to conclude ongoing negotiations – following which, Sri Lanka intends to join the Regional Comprehensive Economic Partnership (RCEP). 

This will set up significant market access for inward FDI into the country and enable Sri Lanka to engage with regional value chains to boost its manufacturing sector. This is expected to be a key catalyst for export growth whilst attracting investment into the economy.

Whilst addressing market access through trade agreements, Sri Lanka is also addressing supply side bottlenecks to boost productivity. A recently drafted labour bill will address numerous inefficiencies in the labour market. The Government is opening up Government owned land for productive commercial activity. Capital market restrictions are gradually being eased as the external imbalances get resolved. 

Public investments will be more focused and targeted in line with fiscal consolidation efforts. These will be channelled to sectors with the highest returns such as digitalisation, including the Unique Digital Identity, education and training, healthcare, renewable energy development, and so on.

Accordingly larger investments and infrastructure will need to be financed by the private sector through Public Private Partnerships and other investment vehicles – creating an important opportunity for investment at scale in Sri Lanka.

However, the biggest short term opportunity in Sri Lanka is tourism. Just prior to COVID-19, Sri Lanka was listed by many of the leading global tourism platforms as one of the top global destinations. At the time Sri Lanka welcomed around 2.3 million tourists per annum (2018) – a very small number compared to most sought-after destinations. 

There is tremendous potential for growth in tourism from several markets, particularly India given its proximity, China, the Middle East, and of course traditional markets in Europe.

Conclusion

Sri Lanka’s attractiveness from an investment perspective has long been apparent but has been thwarted by persistent macroeconomic imbalances. The recent economic crisis has been a catalyst for the long ignored reforms that would finally put an end to these economic vulnerabilities. 

This provides Sri Lanka with the opportunity to finally, fulfil the tremendous potential that has been suppressed for too long. This creates great opportunity from an investment perspective across multiple asset classes.

As inflation returns to single digit levels, locked in by strong institutional and legislative reforms, the expected decline in interest rates creates clear opportunities, in both, equity and, fixed income markets and, lower rates will spur investment in anticipation of economic growth, in the coming period.

From a sectoral perspective, there would be clear opportunities in sectors such as tourism, logistics, and renewable energy, even in the short term, whilst medium to long term opportunities will arise in export manufacturing, technology, and value-added agriculture.

As investment and consumption resume, the macroeconomic path will be guided by fiscal and monetary policies, which do not encourage excess consumption – instead striking an appropriate balance between savings and consumption to ensure investment is channelled to productive sectors. In the past, fiscal profligacy accommodated by monetary largesse, led to large current account deficits and high inflation – a mistake which would not be repeated.

With the reinforced international confidence in Sri Lanka’s stability, we anticipate that our tourism industry will be reinvigorated and the Government aims to create greater trade liberalisation, which is critical to attract investment and boost productivity growth. 

The Government is in the process of establishing a special Economic Commission for External Trade and Investment, to achieve better coordination between different Government agencies. In addition the Colombo Port City Economic Commission has achieved a significant milestone in its efforts to transform the Colombo Port City into a globally competitive special economic zone and, guidelines for granting exemptions or incentives to businesses designated as Businesses of Strategic Importance has been already approved by the parliament. 

The Colombo Port City Economic Commission will be committed to fostering a successful ecosystem that attracts global investment and drives sustainable development in Sri Lanka.

Our aim is to consolidate an economy that is export-oriented, competitive and sustainable and shift towards a private sector driven economy.

To do so, the Government will establish new economic zones across the country, to bolster inflows of FDI essential to unlocking Sri Lanka’s potential. 

We are happy to announce that Sri Lanka recognises both the economic, social and environmental potential of the Blue-Green Economy. Towards this end, various initiatives are taken to fast track our transition towards this end.

In line with our Vision for a ‘Low Carbon Future’, ambitious national commitments are made in line with SDGs to deliver 70% and 100% of the electricity demand through renewable sources by 2030 and 2050 respectively to reach carbon neutral status as a nation by 2050. 

It is a roadmap to attract foreign investment in Sri Lanka’s economy to boost economic growth and employment, while also accelerating climate adaptation and bringing down the country’s greenhouse gas emissions as it transitions towards net negative emissions. The plan is expected to deliver an economic growth rate that is 1% per year higher, resulting in GDP that is 34% higher by 2050.

As Sri Lanka positions itself to embark on rapid economic recovery, followed by sustainable, equitable growth, it is an ideal time for investors to position themselves to benefit from this opportunity.

We wish to say that, we have built on lessons learned from the crisis, to develop the foundations of a stable and prosperous Sri Lanka. 

Let me conclude by reminding you that, Sri Lanka is a safe and peaceful country with welcoming people and is open for the world to experience its beauty and invest in its potential.