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Monday, 27 April 2015 00:05 - - {{hitsCtrl.values.hits}}
Political uncertainty has resulted in volatile economic parameters
This short term uncertainty in the political arena of the island nation has affected the economic stability, mainly in the financial markets with increased volatility in the Colombo Stock Exchange as well as the interest rate environment.
The Stock Exchange in particularly has been on a volatile run in 2015. With the announcement of victory of Sirisena as the new President, the market reacted positively with the expectation of a pro capitalist government as the market gained by 1.4% next day. But the positive euphoria was short-lived with the political and economic uncertainties starting to creep in with market looking for answers on the policy direction of the new Government.
Investors had to rely on news media in the absence of clear communication from the Government on its policy direction, which resulted in the market reacting aggressively to the news items in the country. For instance, news on major infrastructure projects such as the Colombo Port City and the Government’s decision on cancelling casino licenses for large mixed development projects drove the market prices off the counters.
The Interim Budget proposed by the Government revising the previous fiscal budget for 2015 took the market by surprise, especially on the revenue collection aspect as it included several one off tax proposals including the much-discussed super gain tax proposal where companies which made Rs. 2 billion profit for 2013/14 were liable 25% of tax on the profit. Investors became concerned about the ad hoc nature of the proposals and as a result the market saw rapid sell off losing 5% in two trading sessions.
But the market dynamics apparently held off the rapid selling as the ASPI index saw strong support level from 7,000 threshold, and coinciding with the news of a possible continuation of the Port City project the ASPI recovered almost instantly covering the losses recorded due to the selling caused by budget proposals. The negative trend persisted on further uncertainties, but market trend was reversed on Central Bank’s policy rate cut on 15 April.
The country’s interest rates also have become volatile, especially due to the treasury’s requirement to mopping up the liquidity in the system. This is mainly to meet the short term expenditure requirement of the government due to rather challenging revenue collection proposals in the fiscal budget for 2015. It has been trending upwards on the fiscal obligations, but recently has been softening down, with the Central Bank’s monetary easing outlook accommodated by price stability in the country.
On the flipside, inflation has come down significantly with the government’s populist measures in cutting down prices of essential items. For the last month year-on-year headline inflation was only 0.1%, which is the lowest recorded inflation on CCPI. With wage increases, there will be excess income resulting in more consumption in the economy. Furthermore, if the government is able to establish better law and order create feel good factor about the country that too can increase the confidence and efficiency in the economy.
Tale of post-war Sri Lanka
Sri Lanka entered into an era of fast economic growth since the end of the civil conflict in 2009 recording a GDP growth of 7.4% for the last five years. Sri Lanka, a nation with a 20 million population has been transforming itself from a low middle income earning country to a high middle income country at a rather speedy pace despite the benign economic condition that prevailed in the world economy after the global financial crisis.
With the change of economic dimensions, the challenges faced by the economy have started to take a different face. A decade ago the country’s main issues were meeting the people’s basic requirements such as electricity and providing safe drinking water. But with development, now the challenge is to transform Sri Lanka from a middle income country to an industrialised nation. For instance, the new challenges would be to curb corruption, establish good governance, reduce the income disparity, etc. The change of government in January may reflect the expectations of the citizens of the country.
During the last few years, the country’s GDP has been growing predominantly on the back of rapid infrastructure drive fuelled by post-war optimism. The country saw an infrastructure development it has never witnessed before in the post-colonised era, and the Government has opened up the economy for investors to be part of the growth story driving capital inflows required for the infrastructure projects. 
Sri Lanka has leaned towards the fast-growing East to mainly fund the expansion and has become a strong ally of the world’s new economic power house, China. Sri Lanka being located at a strategically-important position in the East-West trading lines made economic/political sense for China also to make the island nation its ally.
Sri Lanka, like most newly-developed economies, has taken the route of debt-fuelled economic growth. The economy historically had significantly high debt compared to GDP and continues to have comparatively high debt to GDP even though it has come down significantly with the GDP growth. Furthermore, the country has to now rely on more expensive commercial loans compared to bilateral loans and grants it was able to attract when it was a low middle income earning economy. Therefore, debt servicing costs have increased significantly during the past few years. Even though it has yet to come to overheated levels the higher debt servicing costs may indicate a potential slowdown of economy, especially when it becomes difficult to attract foreign capital to the country.
Therefore, despite the growth story, it may not be plain sailing for Sri Lanka, on her route to economic development. Sri Lanka has transformed itself to Efficiency Driven economy according to the World Bank’s Global Competitiveness Index. Now it will have to head towards an innovation-driven economy.
Sri Lanka’s per capita GDP has come close to middle income level of $ 4,000, where it is facing a common phenomenon of middle income trap where economies slow down on its growth. Now the country needs to find the leverage to push it across middle income status. The need of the country may have changed with its current economic status. Probably, despite its short-term lapses, the rainbow Government may be the leadership that is required to take Sri Lanka to the next phase of economic prosperity.
New economic paradigm
One of the main criticisms the Government had on the previous regime is the income inequality. The current Government has called for inclusive growth where more people enjoy the benefits of the economic growth and more people will contribute more significantly to the economic growth.
The Government’s Interim Budget proposals announced in January may be driven by populist measures evoked by pending elections, but it also set the direction for inclusive growth by reducing costs of essential goods and increasing salaries so the low income earners will start to contribute more to the economy. Government has also proposed to increase investment into education in a significant manner which is an essential requirement to promote innovation in an economy.
Furthermore, the Government continues to be critical in curtailing corruption in the country and to strengthen law and order. It is still too early to evaluate the effectiveness of the measures taken by the government, but the policy direction seems to set in the correct manner to transform the island nation to a more developed country. Hence, the economy is well positioned to shake off temporary slowdown to continue rapid economic progress aptly aided with a possible social development in the economy.
Economic outlook
The economy has transformed into a relatively low interest, low inflation and stable currency economy with sound policy framework and consistency giving flexibility for economic progression. Sri Lanka historically used to have comparatively high inflation, but now it has been having single digit headline inflation for 74 months and it is expected to maintain low single digit inflation rate in the short term.
The country is quite confident in its balance of payments and the Central Bank continues to opt for a dovish outlook on the backdrop of low inflation. In the last monetary policy review, the Central Bank cut down 50 basis points from policy rates confirming the monetary easing environment. After rather slow credit growth period following the balance of payment issue the country faced in 2011, private credit has started to pick up reflecting increased economic activity.
The country’s fiscal expectations may become challenging in the short term with the populist expenditure measures and rather ad hoc revenue measures, but we can expect budget deficit to continue to be curtailed in the long run putting lesser pressure on financing the growth.
From the external account point of view, it can be expected the tourism receipts continue to grow at a healthy pace and we may see strong growth in main exports, textile with the possibility of regaining GSP+ duty concessions from Europe. Workers’ remittances will continue to play a major role in current receipts and the new government will have more focus on attracting more FDIs to the country, which has been a comparatively lagging factor compared to peer countries.
On imports, fuel bill continues to dominate accounting to about 24% of total imports. Therefore, world oil prices will have a significant impact on the imports, tightening the external sector significantly. But the current downward trending oil prices will continue to benefit Sri Lanka similar to other net oil importing countries.
With inflows and strong reserves position we can expect the currency to continue to be stable. The Sri Lankan Rupee has been comparatively stable despite the strong USD in recent times reflecting the sound reserve position of the country.
In summary, we can see that Sri Lanka is well placed for continuous economic growth despite short term fragility in its political arena.
Investing in new outlook
Accordingly we continue to see strong growth forecasts for Sri Lanka. Despite the downward revision of the country’s GDP growth rate forecasts by international agencies, the numbers still reflect strong growth expectation compared to other countries. Furthermore, Sri Lanka’s proximity to India and India being a stronger ally with the new regime should bode well for the country’s economic progress. Sri Lanka already has an FTA signed with the neighbour, which gives a strong impetus as a hub in South Asia.
The strong economic growth prospects will continue to benefit companies listed in the Colombo Stock Exchange strengthening the respective valuations. Especially with the current political environment the investor sentiment in the short term has been affected to a certain extent, reflected by ASPI’s year to date decline of 2.3% (as at 21 April 2015).
This short term lacklustre price movement will generate more sound investment opportunities as valuation dynamics of the counters would not have changed significantly. Therefore, the current political uncertainty may create equity investment opportunities for smart money at the times of significant price volatilities. Investors in the current outlook can take a leaf from legendary investor Warren Buffet’s manual: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”
