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Tuesday Nov 26, 2024
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John Keells Stock Brokers (JKSB) has released its latest Sri Lanka Market Strategy for 2011. A highly useful document for investors as well as other stakeholders, the report titled ‘Here for the long haul’ has a quick Country Fact Sheet and an Executive Summary in addition to providing brief overviews on politics and economy.
Its key highlight is its market overview and strategy in addition to featuring the investment case on 12 companies, namely Commercial Bank, HNB, Sampath Bank, NDB Bank, Tokyo Cement, Royal Ceramics, Colombo Dockyard, Distilleries Company, Aitken Spence Hotel Holdings, Dialog Axiata, Aitken Spence Plc and John Keells Holdings. Here are excerpts from the report’s political and economic overviews and market overview and strategy:
Political overview
With the removal of the constitutional bar on the president having a two term limit on 8 September 2010, Sri Lanka started a new chapter in its political history. With the ruling United People’s Front Alliance (UPFA) having only 144 seats, the amendment had a smooth passage with 161 members voting in favour, and only 17 voting against.
Current administration firms up hold on power
President Rajapaksa has astutely levered his post war popularity into what appears will be a long stay in the seat of power. The dominance of the Rajapaksa administration is also partially due to the weakness of Sri Lanka’s second major political party the United National Party (UNP). Wracked by internal dissension the party has seen members defect once again to the ruling party while the remaining MPs have publically come out against Ranil Wickremesinghe’s party leadership.
The executive president enjoys enormous powers under the 1978 Constitution.
He can dissolve the Parliament and declare Emergency. He also appoints judges, heads of armed forces and police, election commissioners and secretaries to the government. In a state of Emergency, the president can even promulgate regulations to override laws enacted by the Parliament. The state of Emergency continues to be in force even now though the war ended in May 2009.
Consolidation of power should deliver stability
Sri Lanka has long suffered under political uncertainty with wafer thin majorities in Parliament exacerbating the effects of the turmoil of the nearly three decade long ethnic war. This focus on political uncertainty due to the possibility of a change in regime means many investment decisions were postponed. It is hoped that this current consolidation of political power will give an environment of stability in which faster economic growth can occur.
The Budget delivered in November 2010 underlined the importance the Government places on catching up on the economic development that the country forfeited during its period of turmoil.
Much of the success of the war effort can attributed to the Rajapaksa administration’s foreign policy which prioritised improving relations with regional powers like India and China as well the Middle East. These relationships are also important from an economic standpoint.
India and China are committing substantial amounts to investment in infrastructure in post-war Sri Lanka. China is now Sri Lanka’s largest donor of developmental assistance after Japan. India is also one of Sri Lanka’s most important trade partners and is one of the largest sources of tourists into the country. Sri Lanka’s increasing links to the Asian region should prove important in continuing export led economic growth in the coming years.
Economic overview
With the peace dividend filtering in, the economy is expected to have grown at 8% in CY2010 having gathered healthy momentum with five consecutive quarters of accelerating growth from 2Q2009 to 2Q2010. The last eight months have seen a sharp improvement in business activity after a rebound in the wider economy lagged initial expectations as businesses adjusted to an abrupt end in hostilities in mid 2009 and then held back till the conclusion of parliamentary and legislative elections in early 2010.
The economy has witnessed a significant improvement in business sentiment and business activity stemming from a benign interest rate regime and fiscal reforms resulting in a lower and simplified taxation and tariff structure. Furthermore overall macro level stability and an increased infrastructure spend together with an upturn in domestic demand have collectively underpinned a strengthened economy.
Credit growth which was marginal for much of 2008 and marginally negative for 2009 picked up sharply in the 2H of 2010 to end the year up an estimated 22.6% for CY2010. The resurgence of intra provincial trade with the reintegration of the North and East Provinces to the main stream economy, the significant and simultaneous infrastructure spend across the island in road, power, port and rural infrastructure development and the consequent multiplier effects feeding into increased domestic consumption underlie our medium term expectations of 8%+ GDP expansion.
Sustaining this growth momentum beyond will however require a significant increase in FDI across a number of sectors to drive scale and productivity enhancements in the economy.
Severe floods earlier this year in the North Central and Eastern Provinces will result in a significant reduction in agricultural production in the first half of the year as a result of lost cultivation and damage caused to irrigation infrastructure.
The agriculture forestry and fisheries sector recorded a 6.2% growth for the 3Q stemming from the highest ever recorded paddy production during the 2009/2010 ‘Maha Season’; which accounts for approximately 65% of total paddy production in the country. The ‘Yala Season’ also witnessed a 21.4% increase in the area harvested over the previous year while yields also improved.
The total gross area harvested during the ‘Maha’ and ‘Yala’ season in 2009 amounted to 943,000Ha which could increase by as much as 10%-15% in 2011/2012 should weather conditions be favourable, with increased land in the North and East being cultivated. The revised production figure following the floods for the ‘Maha Season’ is 2.3mn MT which is marginally lower than the 2009 output and a 24.5% decline for this year’s expected crop levels. Other field crops have seen a similar effect in loss of cultivated area.
The fisheries sector grew by 14.4% in the 3Q 2010 with marine fishing growing by 15.3% with some of the most fertile fishing grounds of the North and East coast representing two thirds of the country’s coast line seeing increased production. Output of the country’s traditional exports witnessed sound growth with record prices for tea and rubber benefiting from strong external demand for commodities.
The commercial construction sector is gathering pace with loan disbursements for construction related activity increasing by 25.2% in the 3Q 2010 while cement production was up 20.6% yoy for the first 11 months of 2010. A strong pipeline of large scale infrastructure projects relating to expressways, increased power generation capacity, sea ports and airports as well as rural infrastructure development initiatives across the island will sustain this growth momentum over the medium term.
The manufacturing segment which accounts for nearly 75% of industrial output in the country recorded steady growth of 6.8% in the 3Q with the garment sector remaining resilient following the suspension of the EU GSP + facility whilst other sub sectors will see increased capacity utilisation.
Expansion of the import trade sector as well as a pickup in domestic trade into the North and East Provinces and increased consumer spending across the island is expected to drive growth in the services sector. Import trade increased by 11.8% in the 3Q 2010 benefiting from a reduction in import tariffs in July for motor vehicles and a whole range of consumer products.
Credit penetration has also increased sharply with the banking, insurance and real estate sector expanding by 8.5% in the 3Q, with private sector credit growth which was moderate for the 1H 2010 increasing sharply up 25% up to November last year. We anticipate credit growth to the private sector to average at 25% over the next two years.
The hotel and restaurant sector benefited from an anticipated 46% increase in tourist arrivals with the sector growing by 32.2% for the 3Q in 2010 which followed a 20.6% expansion in the sub sector in the 3Q 2009. The transportation sector is also expected to expand sharply over the medium term driven by growth in cargo throughput and container handling at the port which was up by 18.9% and 12.9% respectively in the 3Q. Increased air travel as well as passenger and goods transportation within the country will further augment growth in the sector.
Government revenue from taxes and grants increased by 14.4% for the first 11 months of CY10 whilst recurrent expenditure recorded a modest growth of just 3.7% in the same period, and as such we believe that approved estimates for CY10 of revenue to GDP of 14.8% and a budget deficit of 8% will be met. The budget proposals announced for 2011 express an intention to bring down the fiscal deficit to 6.8% in 2011 and 5% in 2012, with the initial MEFP attached to the LOI signed for the IMF Standby facility being to bring down the fiscal deficit to 5% by 2011. We anticipate the fiscal deficit would decline to 7% for 2011 stemming from lower interest expense on domestic financing, higher tax revenues and lower defense expenditure relative to GDP. The taxation reforms spelt out at budget proposals for 2011 announced on the 22nd of November were well received and marked significant changes with the state boldly reducing and simplifying taxation structures for corporates and individuals in a bid to improve revenues by facilitating growth as opposed to the imposition of a host of adhoc taxes as was seen in the past. We do not anticipate a significant curtailment of recurrent expenditure in 2011 except for a moderate reduction in defense expenditure to GDP.
The CCPI has been trending higher from an annual average of 3.1% in February 2010 to 6.0% in January 2011 driven primarily by higher food prices which account for approximately 47% of the CCPI index. The loss of crop production due to the floods earlier this year will add further supply side pressure on food prices which we expect would push the CCPI up to 8.8% by end 2011, which is subject to revision depending on movements in oil prices.
Increased food production in the North and East Provinces and improved yields should cushion the country’s exposure to imported inflation on food items in the medium to long term although the country’s exposure to supply side shocks still remains significant with its sensitivity to global commodity prices such as petroleum imports.
The property market is still relatively subdued and non-food and non-fuel inflation still remains under check reflecting unutilised capacity in the system although demand driven inflationary effects may begin to be evident towards the latter half of the year. The immediate concerns for this year however remain on supply side shocks from food as mentioned earlier and more significantly the impact on oil prices from recent events in the Middle East.
Interest rates have continued to trend lower with the 1 yr T-bill and weighted average prime lending rate down to 7.33% and 9.12% from 9.47% and 10.83% respectively a year earlier. The Central Bank eased policy rates in January with the Central Bank’s repurchase rate brought down by 25bps to 7.00% and the reverse repo rate down by 50bps to 8.50%. With inflation trending higher we believe that interest rates have bottomed out and prime lending rates may rise by 50bps by year end with prospects of strong credit growth remaining intact.
External trade
Export earnings for the first 11 months of 2010 were up 15.4% stemming from industrial exports and agricultural exports. Industrial exports recorded a 13.6% growth on the back of exports of product categories such as boats and rubber products while garment exports increased by 3.7% in the same period. Much of the growth in the sector stemmed from agricultural exports which grew by 21.7% accounting for 25.2% of exports for the period. This was largely due to high tea and rubber prices.
The garment sector is expected to remain resilient despite the loss of the GSP+ facility, aided by a modest recovery in key western markets and increasing labour costs in China and labour unrest in Bangladesh enhancing the local industries’ competitiveness. We expect exports to grow by 15.2% in CY10 and by 13.3% in CY11.
Total imports for the first 11 months of 2010 were up 32.6% driven by a 45.2% increase in import of consumer goods and a 33.6% increase in intermediate goods. The increase in consumer goods was predominately a result of non-food consumer goods led by motor vehicles while the 33.6% increase in intermediate goods was a result of a value driven growth of 45.8% in petroleum imports. Continued import of non-food consumer goods such as consumer electronics and motor vehicles together with an increasing oil import bill and import of industrial input materials is expected to see imports grow by 18% in CY11.
The trade deficit is expected to have widened by 73% for CY10 as a result of a sharp rise in imports which contracted in 2009. Garment and textile exports which accounted for approximately 46% of total exports in 2010 is expected to grow at just 6% in 2011, with total exports expected to grow at 13.3%. Anticipated growth in imports of 18% driven by petroleum products and non food consumer goods is expected to result in the trade deficit expanding by 24% in 2011.
Net remittances have remained strong amounting to US$ 3.4 b for the first 11 months in 2010, a 24.6% increase over the previous year. Total net remittances are expected to amount to US$ 4.1 b CY11 substantially offsetting the trade deficit. Strong inflows to Government securities in 2010 along with the sixth tranche of the IMF standby facility have pushed gross official reserves to US$ 6.6 b, equivalent to six months of imports. Up to US$ 1.5 b has now been released by the IMF as part of a US$ 2.6 b standby facility.
The Central Bank has continued its stance of retaining a soft peg against the US$ which has prevented a sharper appreciation of the LKR against the US$. The local currency has appreciated by a marginal 0.03% against the US$ since the start of this year whilst depreciating by 2.67% and 1.99% against the Sterling and Euro respectively. Whilst we expect investment flows to remain strong in the current year the Central Bank is expected to continue to intervene to help exporters retain competitiveness and retain stability in the exchange rates.
