Why Lion leads frontier

Following is the part one of the Daily FT article featuring the Acuity Stockbrokers Research on Economy and Strategy titled “Lion Leads Frontier” launched last week.

Better than the rest

General frontier market risks remain pertinent to

Sri Lanka

Investors in frontier markets are well aware of the risk-return tradeoff intrinsic to these markets. Low liquidity, weak corporate transparency, institutional issues and political instability are undoubtedly onerous, but they are for the most part, offset by the returns and diversification benefits these markets provide. Thus, in the last five years, frontier markets have become a prominent investment class for investors with long horizons and high risk tolerance. Most investors nonetheless, take the view that frontier market equities deserve to trade at a discount.

Sri Lankan markets are clearly not above the issues that demarcate frontier markets. Low liquidity and currency volatility for example continue to afflict Sri Lankan markets. Compared to its immediate peers in the frontier market sphere though, Sri Lanka’s post-2008 liquidity position is improving significantly. Market Capitalization as a percentage of GDP (a broad measure of liquidity) in Sri Lanka has improved sequentially since 2008. But, at approximately 33% of GDP this continues to represent low liquidity. Still, relative to Pakistan, Vietnam and Bangladesh where market capitalization as a percentage of GDP has ranged between 8%-22% during 2008-10, this compares favourably. We acknowledge though, that the post-war bull-run in equities is partly accountable for this improving liquidity position.

A look at stocks traded as a percentage of GDP underscores this. Stocks traded as a percent of GDP represent the total value of shares traded during a period and is another broad indicator of liquidity. Here, we see that while Sri Lanka’s liquidity position is lower than that of its peers, it has improved significantly post-2009. Thus, although Sri Lanka’s liquidity conditions have been low in the past, it has been improving considerably.

The basis for our investment case however, lies elsewhere. We maintain that while frontier market specific issues such as low liquidity and volatile exchange rates may continue, at an institutional level the case for Sri Lanka is robust. Sri Lanka’s greatest trump card in this context is its new found political stability. With the war - Sri Lanka’s Achilles’ heel thus far – concluded other risk factors such as institutional and corporate transparency issues take prominence. However, our view is that despite room for improvement, Sri Lanka’s position on these fronts has always been stronger than that of its frontier market counterparts.

At a broad institutional level and in terms of correlation to global equities Sri Lanka compares well

Quantifying regulatory and institutional risks is notoriously difficult and beyond the scope of this report. Moreover, while there may be surveys to determine a country’s broad institutional framework, competitiveness and ease of doing business, there are no independent cross-country surveys to assess specific regulatory aspects. Thus, for example, while there are no surveys to compare specific aspects of stock market regulation across countries, there are surveys which broadly gauge how easy it is to do business.

In this context, we view Sri Lanka’s recent measures to improve its broad institutional framework positively. During 2011, the regulatory and supervisory framework of the financial sector was reinforced, while corporates were mandated to transition from the current financial reporting standard to the more globally compatible IFRS standard. International surveys which measure ease of doing business and competitiveness have in fact recognized Sri Lanka’s recent measures to improve its broad institutional framework.

Of course, room for improvement remains. Operating a business in Sri Lanka’s remains challenging given the red-tape and bureaucracy involved. Yet our point is that from the perspective of an overseas participant looking to enter the frontier market sphere, Sri Lanka compares well. Our case for Sri Lanka is simple therefore. Relative to its immediate frontier market peers, Sri Lanka’s institutional and political framework is strong, and on this basis generates high investor returns since the risk-return tradeoff is skewed more towards returns.

Fundamentally sound

This, however, is not our only case for Sri Lanka. Frontier markets are innately attractive for the low correlation they have to other global equities and the diversification benefits they consequently provide. In light of the current global economic scenario, this gains precedence. The tentative global recovery that has emerged post the 2007 global financial crisis underscores the shift in balance of economic activity. Much of the developing world is still seeing relatively strong growth (despite some downside risk due to overheating). Conversely, advanced economies are experiencing a sluggish recovery, persistent unemployment, and financial vulnerability. Given this shifting global economic scale, we believe the case for frontier market equities is strong. Sri Lankan equities which are even less correlated to global equities than its frontier market counterparts thus provide excellent diversification benefits.

At a fundamental level too the case for Sri Lanka is compelling

On comparative terms, therefore, our case for Sri Lanka is strong. However, Sri Lankan fundamentals are equally attractive. The end of the war has prefaced a new economic chapter for Sri Lanka and investor confidence in the recent past has improved vastly on expectations of the country kindling its untapped potential. Growth potential has improved in leaps and bounds post-war, with the peace dividend, though embryonic, beginning to show. Growth in the last two years has averaged 8.1%, a distinct contrast to the historical average of 5.0%.

Recent headwinds to growth are, in our view, a short-term correction. Policy measures to correct domestic imbalances by reining in the current account deficit, trimming reserve losses and tempering credit growth are undoubtedly prudent. They do however, come at a price. These measures have resulted in a significantly weaker LKR, higher interest rates, lending curbs and tighter import taxes. Couple these with the sluggish global recovery and we have significant downside risks to growth. Unsurprisingly therefore, we see growth in 2012 slipping down to 7.0%.

This dip though is a temporary deviation from our positive medium to long-term forecasts. We see growth at 7.5% in 2013 and 8.0% in 2014 as capacity utilization increases due to improved efficiencies and greater resource availability post-war. The end of the war has several positive economic implications. Resources can now be diverted towards developing and rehabilitating weak infrastructure which in turn will increase efficiencies. New business opportunities have also emerged. For example, Sri Lanka’s geographical location when coupled with the post-war re-opening and development of the country’s habours and ports provides entrepot and industrial trade opportunities. Tourism - which has flourished post-2009 - can be expanded in to new segments such as niche and emerging markets. The possible discovery and commercial viability of Oil resources in Mannar could also boost longer-term economic prospects.

We also expect the Balance of Payment to be in surplus between 2012-14. This is despite the country’s trade deficit easing only gradually. We believe that continued inflows into the capital account along with emerging new trends in the services component of the current account make sustainable BoP surpluses feasible. Direct and portfolio investment inflows to the private sector and government should increase as the LKR depreciates further in the immediate short term, and as FX control regulations are relaxed further. Meanwhile, the medium to long-term potential of services exports has become progressively clearer as the contribution from these to the overall current account balance has increased markedly post-war.

Cost-push factors may pressure short term inflation up, but medium to long-term inflation should be stable. Sharp spikes in broad money supply are unlikely going forward as credit to the private sector is monitored more closely. Credit to Government too is likely to be tempered as the Government tries to maintain its fiscal deficit targets. Our view on rates is thus also mixed. Short-term, we expect some upward movement but expect dovishness in the medium to long-term. Money market liquidity has tightened since Q4 2011 as voracious credit growth coupled with the monetary board’s defense of the LKR has severely strained domestic liquidity. The consequent increase in policy rates has not wholly resolved the situation. Given the depreciating currency, we believe that interest rates will have to edge up slightly higher in the immediate short-term. This however, will be a temporary phenomenon. We see medium-term rates moderating as inflationary pressures ease and the LKR regains some strength.

In sum, we believe Sri Lanka displays significant investment potential. Our view is supported both at a comparative and fundamental level. While we concede that downside risks –namely worsening global economic conditions – exist, we remain optimistic and believe our position is justified based on improving economic fundamentals.

Better institutional framework

Doing business in Sri Lanka has gotten easier

post-war

Our base case for Sri Lanka is straightforward. Relative to its immediate frontier market peers, Sri Lanka’s broad institutional framework - which has always being comparatively strong - has gotten stronger post-war. Given that low corporate transparency, institutional issues and political instability are risk factors that investors face in all frontier markets, we believe the case for Sri Lanka is convincing. We grant that frontier market specific issues such as low liquidity and volatile exchange rates are unlikely to dissipate short term. However, we believe that Sri Lanka’s new-found political stability has given the country’s institutional framework a boost in the form of prompting greater accessibility. To explain this transition, we look at a number of independent global surveys, namely Doing Business, the Global Competiveness Index, and the Change Readiness Index. We reiterate that while these surveys do not assess specific regulatory aspects across countries, they do at an approximate level gauge the ease of doing business abroad.

The World Bank/IFC’s ‘Doing Business’ survey essentially measures how feasible it is for entrepreneurs to open and run small to medium size businesses while complying with the relevant regulations. The survey measures and tracks regulatory changes in 10 specific areas of a business’ life cycle, namely starting a business, dealing with construction permits, getting electricity, registering property, getting credit, protecting investors, paying taxes, trading across borders, enforcing contracts and resolving insolvency.

Globally, Sri Lanka ranks 89th out of 183 economies in the Ease of Doing Business rankings, making it South Asia’s 2nd best in 2012. Sri Lanka moved up 9 places from its 2011 rank of 98 and is a further improvement from its rank of 101 prior to the end of the war (2008).

This noteworthy performance is largely attributable to i) improved investor protection - a measure of how well protected minority shareholders are against directors’ use of corporate assets for personal use & gain - and ii) reductions in taxes on business. Sri Lanka strengthened investor protection in 2011 by requiring greater corporate transparency on transactions between interested parties. This policy move resulted in the country improving dramatically (from 74 in 2011 to 46 in 2012) in the area of ‘Protecting Investors’. Sri Lanka also made paying taxes less costly for businesses by abolishing turnover tax and reducing corporate income tax and Value Added Tax (VAT).

In other indicators - such as starting a business, trading across borders and resolving insolvency - too Sri Lanka is ranked comparatively higher.

The cost (% of income per capita) of starting a business in Sri Lanka decreased from 5.4% in 2011 to 4.7% in 2012, making it the regional best performer. In terms of trading across borders - a measure of the time and cost associated with shipping and procedural requirements such as documentation - Sri Lanka is 53 (out of 183 countries) relative to 72 in 2011 and far above the regional average of 124. This improved position reflects the positive effects of reforms implemented to facilitate better economic trade.

Meanwhile, Sri Lanka is placed 42nd on the ease of resolving insolvency, 99 being the regional average. Resolving insolvency in Sri Lanka takes 1.7 years on average with an average recovery rate of USD 0.48.

Improved accessibility post-war

Sri Lanka’s competitiveness improves

The Global Competitiveness Index1 2011-2012 ranks Sri Lanka 52nd out of 142 countries, an impressive jump of 10 places from 62 last year. The Index measures the microeconomic and macroeconomic foundations of national competitiveness using 12 ‘pillars’ or components, each of which measure an aspect of competitiveness. Competitiveness, as defined by the index, is the set of institutions, policies, and factors that determine a country’s level of productivity. The level of productivity, in turn, sets the prosperity levels that an economy can earn. The productivity level also determines the rates of return obtained by investments in an economy, which in turn are the fundamental drivers of its growth rates. In sum, a more competitive economy is one that is likely to grow faster over time.

Sri Lanka made significant year-on-year improvements in pillars such as ‘Infrastructure’ (rising from rank 70 to 60), ‘Macroeconomic stability’ (up by 8 places to 116) and Efficiency enhancement components such as ‘Financial Market Development’ (from rank 52 to 45 in 2012). Sri Lanka’s position is strong amongst the ‘Developing Asia’ country group, albeit somewhat lagging behind some of the more dynamic economies in South East Asia.

Sri Lanka Scores High on its Capacity to Change

The KPMG and ODI Change Readiness Index assesses countries’ ability to manage change and cultivate opportunity on the underlying assumption that effective management of change is key to achieving sustained growth. The Index covers 60 countries and focuses largely on developing and emerging markets, most of which target significant economic development. The Index provides a different perspective to conventional performance measures such as the Global Competitiveness Index; thus, even countries that have poor economic resources (e.g. a limited natural resource base or poor geography) or have performed poorly to date, can potentially score well if they have in place a more promising economic, governance and social foundation for future, sustained growth.

The Index categorizes the factors determining capability to manage change into three broad groups (sub-indices), namely Economic Capability, Governance Capability and Social Capability. Economic Capabilities refer to the private sector’s ability to respond to change and generate dynamic growth while also measuring public investment’s contribution in achieving these goals. Governance Capability relates to governmental and regulatory institutions’ ability to manage change effectively, along with private sector governance mechanisms. Social Capability meanwhile, relates to the societal and cultural competencies to manage change.

Sri Lanka’s position in the Index is high. The country ranks 22nd out of 60 in the overall Index, far above its immediate frontier market peers which rank below 40. Sri Lanka’s sub-Index rankings too indicate that across the three spheres, the country’s adaptability and capability to change is strong.

Meanwhile, Transparency International ranks Sri Lanka 86th out of 183 countries in the Global Corruption Perception Index 2011.

This Index ranks economies according to their perceived levels of public sector corruption. Sri Lanka has improved its ranking from 91 in 2010 and is currently among the top rankers in ‘Developing Asia’

Thus, in our view, although doing business in Sri Lanka has always been relatively easier, this ease has improved post-war. Sri Lanka’s ascension across a number of global surveys mirrors this and reflects the country’s relatively sounder institutional underpinnings, a key area for efficient and effective businesses.