Value investors enter as speculators exit

Key insights to state of the economy and market and future prospects from NDB Stockbrokers’ latest Sri Lanka Equities report

Uncertainty in the macro environment

The robust economic growth and steep rise in global crude oil prices increased Sri Lanka’s import bill by 51% in 2011. As a result the trade deficit widened, putting the rupee under severe pressure to depreciate.

The Central Bank intervened to avoid the rupee from depreciating at the expense of a drastic reduction in foreign reserves. Simultaneously the Central Bank avoided a rise in interest rates by increasing its holdings of treasury bills. As the Central Bank limited intervention in early 2012, rupee was depreciated by over 13% while interest rates (1-year Treasury bill rates) shot up by 3% as uncertainty set in.

Stability to return over the next few months

While we feel less intervention during the latter part of 2011 could have avoided the current environment of uncertainty, a number of measures have been taken in the early part of 2012 to stabilise (and slow down) the economy.

We expect the increased workers’ remittances and inflows to the corporate debt and equity markets to result in a surplus in the Balance of Payments in 2012 compared to a deficit in 2011. Accordingly the exchange rate is likely to strengthen slightly from the current level and stabilise.

The private sector credit growth is likely to reduce sharply with the slowdown in the economy. In addition with the increased foreign inflows to the corporate debt market we expect the interest rates to stabilise at a slightly lower rate to what is prevailing currently.

Global uncertainty a serious challenge

However the increasingly volatile and uncertain global environment poses a serious threat to economic stability. Further deterioration in the economic and political crisis in Europe will affect capital inflows as well as exports from Sri Lanka (although it would bring down crude oil prices). A global reduction in imports of crude oil from Iran could increase crude oil prices in July increasing the petroleum bill (putting pressure on the trade deficit once more).

Bull run could resume from latter part of 2012

Provided the global environment does not deteriorate significantly, we feel the prospects in the equity market to improve from the latter part of 2012. The attractive prices (and valuations) and higher corporate profit growth prospects compared to regional markets and the significant reduction in excessive speculation has placed Sri Lankan equities once again in the path of a bull run.

Import bill sky rockets

Sri Lankan economy grew at 8.3% in 2011, the highest recorded in its post-independence history. This was achieved predominantly by the spike in demand for imports (which increased by 51% compared to 2010), in the absence of natural resources such as crude oil and the infant level of development in the manufacturing base.

The increased consumption levels have propelled the demand for vehicles and home appliances (categorised under “Consumer”). The growth in vehicle population coupled with the steep increase in world crude oil prices and the dry weather which increased the demand for thermal power plants had ballooned the bill on petroleum products by 58%. Petroleum products have contributed to a significant 24% of total imports (categorised under “Intermediate”). Pick up in expenditure on machinery and equipment by 60% is reflected in the rise in “Investment” activities.

Relatively modest increase in exports

On the other hand, export earnings grew at a significantly lower rate of 22% in 2011. Sri Lanka possesses a relatively small export base which is concentrated on few basic sectors such as tea, textiles and garments (which contributes 54% to total exports). While poor weather throughout 2011 curbed growth in agricultural exports, economic slowdown in Europe and high cotton prices affected the textiles and garments sectors.

Trade deficit widens beyond control

The mounting imports in comparison to a modest increase in exports widened the trade deficit particularly in 2011H2. The resultant heavy US$ outflows compared to US$ inflows put severe pressure on the rupee exchange rate.

Central Bank’s expectation did not materialise

The Central Bank intervened in the foreign exchange market in 2011H2 to maintain the rupee exchange rate. External reserves declined sharply as the Central Bank sold US$ in the market. The Central Bank’s expectation may have been for significant capital and financial inflows which could have eased the pressure on the exchange rate.

In addition to intervening in the foreign exchange market, the Central Bank also resisted a rise in market interest rates. This was by way of pumping rupees into the economy by increasing its holdings of treasury bills (the process known as “sterilised intervention”).

Lack of foreign direct investments in equity is a cause for concern

Although the financial inflows increased in 2011, it was not sufficient to bridge the trade deficit, resulting in a Balance of Payment (BOP) deficit of US$ 1,061 Mn (compared to a surplus of US$ 921 Mn in 2010).

The majority of the inflows in the financial account were in the form of government loans (including the sovereign bond). Similarly, out of the inflows to the private sector, majority were in the form of loans. It should be noted that foreign equity investments (including retained earnings) was US$ 251 Mn in 2011.

Over-valued rupee and low interest rates aggravated the problem

The rupee should have depreciated in 2011H2 in the wake of mounting BOP deficit (most Asian currencies depreciated against the US$ in 2011H2). A gradual depreciation of the rupee could have reduced the demand for imports, alleviating the widening trade deficit. In addition the steep reduction in interest rates up to 2011H1 and the relatively low interest rates that prevailed during the major part of 2011 also boosted the demand for imports.

Sudden depreciation of rupee and rising interest rates have caused panic

As the pressure on exchange rate intensified, the rupee was devalued by 3% at the budget proposals in November 2011. While it is unique to announce a change in monetary policy in a fiscal policy document, the Central Bank continued to intervene to defend the new value of the rupee up to January 2012.

However since February the Central Bank has curtailed intervening in the foreign exchange market. The sudden action of the Central Bank increased speculation and uncertainty regarding the exchange rate, as the rupee depreciated by around 13% in February – March 2012 (to over Rs 130 per US$). The exchange rate remained volatile in April.

In hindsight we feel the exchange rate should have been allowed to depreciate (from Rs 111 per US$) gradually from September 2011 onwards. In that case the exchange rate may have stabilised at a stronger level by early 2012. In our previous update in November 2011 we did not foresee a steep depreciation of the rupee as the trade deficit (and the other economic data) only up to August 2011 was published at that time. However we did mention that “the strong demand for imports which is already adversely affecting the trade deficit could put pressure on the exchange rate”.

Similarly had the Central Bank not provided liquidity to the market, the interest rates would have increased rapidly from September 2011 onwards and may have stabilised by early 2012. In our opinion the 1 year Treasury Bill rate would have stabilised at a lower rate instead of over 12% at present. In our previous update we opined that “the interest rates are likely to increase by around 1%” while the rates have increased by over 3% since then. However we did state “increase in interest rates would be more significant if foreign inflows to the debt market slow down”. As mentioned earlier foreign inflows were below expectations in the latter part of 2011.

Foreign inflows to corporate debt to gain momentum

The gradual liberalisation of the debt market to foreign investors is likely to increase foreign inflows to the country. The successful over-subscription (by over 7 times) of the US$ 500 Mn bond issue of Bank of Ceylon is an encouraging sign and we expect further inflows to Tier II capital of commercial banks in 2012.

The Foreign Direct Investments (FDIs) in equity is also likely to pick up in 2012 from low levels in 2011. However we feel further work needs to be done to attract foreign direct investments. Equity investments reflect the confidence in investors that the venture has profit making capacity whereas debt investments do not reflect the same level of confidence in the venture.

Pressure on Balance of Payment will reduce

The depreciation of the rupee, increased interest rates, taxes for imports and fuel prices will have a significant negative impact on the demand for imports in 2012. On the other hand the impact on exports will be neutral as the adverse impact of higher interest rates and fuel prices could be negated by the depreciation of the rupee. Accordingly we expect the trade deficit to maintain at 2011 levels in 2012.

In view of the increase in workers’ remittances and tourism sector earnings we estimate the Current Account deficit to reduce from US$ 4,615 in 2011 to US$ 3,500 in 2012. We also expect a BOP surplus of around US$ 500 Mn in 2012 compared to the deficit of US$ 1,061 Mn recorded in 2011 due to increased inflows to the Financial Account.

However strong long term measures need to be implemented to rectify Sri Lanka’s structural problem of a recurring high trade deficit. In the absence of natural resources such as crude oil and the relatively small size of the Sri Lankan market (population of only 20.9 Mn) promoting import substitution industries in a large scale may have only limited success. Sri Lanka will have to formulate a plan to utilise its unique advantage of the strategic location in the Indian Ocean. In this regard the successful and timely implementation of the Hambantota and Colombo ports is crucial to boost foreign currency earnings.

Exchange rate to stabilise

We expect the exchange rate to stabilise between Rs 123 – 128 per US$ in 2012H2 with the expected surplus in the BOP. Since 1978 up to 2000 the rupee has depreciated by 8% p.a on average against the US$. However the rupee depreciation from 2001 to 2009 was slightly over 3%. Significant increase in workers’ remittances since 2001 seems to have helped the rupee to be more stable against the US$.

We estimate the annual average rupee depreciation to be 3% in the foreseeable future. The trade deficit will have to be reduced significantly in the long run for the rupee to be more stable.

Credit growth likely to slowdown

Credit growth which was robust in 2011H1 further intensified in 2011H2. It shot up to unprecedented levels in the first two months of 2012. As mentioned previously had the currency been allowed to depreciate and interest rates were allowed to increase, the credit growth would have subdued significantly by early 2012.

Private sector credit growth is expected to slow down significantly to 15 – 20% in 2012 (compared to 35% in 2011) as the higher interest rates and the increase in costs (imports, fuel etc) will have a negative impact on demand.

The government tax revenue is likely to be negatively affected in 2012 with the reduction in imports and general slowdown in the growth of the economy. Therefore we expect the overall fiscal deficit to exceed Rs 500 Bn (compared to Rs 450 Bn in 2011). As a result government credit growth could remain relatively high around 20 – 25% (compared to 33% in 2011).

Accordingly we expect the overall credit growth to slow down to around 20% in 2012 compared to 34% in 2011.

Interest rates to stabilise

Along with the drop in demand for credit, the increased foreign inflows to the debt market would stabilise the interest rates.

The US$ borrowing cost of around 10 – 11% in rupee terms (inclusive of annual average rupee depreciation) may provide a ceiling for the fixed deposit rates offered by banks. Accordingly we expect the 1 year Treasury Bill rate to stabilise around 11 – 12% in 2012H2 (from the current level of over 12%).

Inflation to increase moderately

Headline inflation was maintained at 6.7% in 2011 slightly below our previous forecast of 7.0%. Over the last 12 months the headline inflation has moved in tandem with core inflation (which tracks the inflation excluding food and energy prices).

The easing of credit growth in 2012 would also be reflected in the slowdown of the growth in money supply. This would help to maintain demand driven inflation. Accordingly we do not foresee a reason to further increase policy rates.

However inflation would be under pressure due to high global commodity prices (crude oil in particular). Even if global crude oil prices come down slightly the local prices are unlikely to reduce as the prices are still subsidised. The increase in domestic supply of agricultural items would help to stem supply side driven inflation. This could explain the similar movement of headline and core inflation since April 2011.

We expect headline inflation to increase to around 8%-9% in 2012 mainly due to supply side factors which are beyond the control of the monetary authority.

Precarious global environment is a serious challenge

The increasingly volatile and uncertain global economic environment poses a serious threat to economic stability in Sri Lanka as well. Further deterioration in the economic and political crisis in Europe will affect capital inflows as well as exports (although it would reduce global crude oil prices). Influence of USA to reduce imports of crude oil from Iran could increase petroleum bill putting pressure on the trade deficit. Signs of slowing down in China and India could seriously affect global economic growth prospects. In this volatile global environment forecasting economic variables becomes extremely difficult.

Economic growth will slow down

GDP growth was recorded at 8.3% for 2011 well above our previous estimate of 7.5 – 8.0%. However the growth would have slowed down slightly to a more sustainable level if the rupee had depreciated and the interest rates were allowed to increase over the last few months of 2011. In contrast to Sri Lanka, global economies have slowed down in 2011 compared to 2010.

The number of steps taken to stabilise the economy has increased the general cost structure which will affect economic growth in 2012. We estimate the GDP growth to be around 6.5% in 2012. We also reduce our medium term (2012 – 2014) sustainable economic growth forecast to 7% from 8%. However it should be noted that most global economies have revised their growth forecasts downwards for 2012 over the last 6 months. Hence Sri Lanka’s growth will continue to outperform the average growth of emerging economies over the next 3 years.

Corporate profit growth to slow down in 2012

Corporate profit growth was recorded around 25% for 2011, well below our expectation of 40%. It is expected to reduce in 2012 as economic growth slows down. Accordingly we revise our profit growth estimates in 2012 to 10% from our previous estimate of 25%. However we expect it to increase to 20% in 2013 before settling to a sustainable level of 15% from 2014 onwards.

We expect the profit growth in Sri Lanka to exceed the average growth in the region over the next 3 years.

Valuations remain attractive

According to our estimates the broad market is trading at a trailing P/E of 12x (based on 2011 earnings). This is lower compared to the average trailing P/E of 14x witnessed in regional markets. Once the current economic uncertainty eases over the next few months we expect investor sentiment on Sri Lanka equities to improve substantially. Therefore we maintain our expected P/E of 15x over the next 3 year time horizon.

Excessive speculation has greatly reduced

In our publication in May 2011 we mentioned “excessive speculative trading can result in a crash”. Overall market declined by close to 20% from 2011 May to November 2011. In our last publication in November 2011 we mentioned “the prevailing shortage of liquidity in the market is likely to keep prices stagnant (or even decline) in the short term”. The overall market has declined by around 15% so far in 2012 in contrast to global markets which have performed much better.

We also stated in our previous publication that “we advise investors to be cautious since a revival of excessive speculation may result in the ASPI not reaching our target”. Excessive speculative trading that was rampant in 2011 has reduced significantly over the last 6 months. Therefore, we believe the long term prospects of the equity market have been reinstated to a significant extent with the steep reduction in the prices of speculative counters.

Fundamentals based investors increasingly attracted to equities

As speculative investors were exiting the equity market, fundamentals based investors are being attracted with the attractive prices prevailing. For example the foreign investors who were largely exiting the equity market in 2010 and 2011 are steadily returning in 2012.

Bull run could resume from latter part of 2012

The current macro level uncertainty regarding interest rates and exchange rate has negatively affected the equity market. We feel the interest rates and exchange rate should stabilise over the next 3-month period, provided the global economic and political environment does not deteriorate significantly.

Stability in the macro environment coupled with attractive valuations should attract investors to equities. The significant reduction in speculative activity would assist in this regard. Therefore, we maintain our previous ASPI target of 9000 (by end of 2014) and expect the bull run to resume from the latter part of 2012.