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Sri Lanka Economic Outlook 2013

RAM Ratings Lanka Ltd.



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Despite Sri Lanka’s stellar growth in recent years, global headwinds and policy measures to curb demand remain key considerations through the rest of 2012 and next year. As such, we have revised our GDP growth forecast to 6.5% for this year, followed by 7.0% in 2013 as a clearer resolution to the global crisis emerges.


Global conditions


Risks remain largely unchanged. The United States ("US") has been posting a modest recovery, which may be hampered by political brinkmanship in the lead-up to its imminent presidential elections later this year. Similarly, policy constraints and ineffectiveness are retarding recovery in the European Union ("EU"). With the growth effects of reconstruction efforts beginning to wear off, Japan’s rebound hinges on global economic stability. Elsewhere, China’s domestic demand is still able to offset external weaknesses.


Private Consumption


Eager to lift the spirit and economy of the post-war nation, the Sri Lankan government introduced several liberalisation and rationalisation policies in 2011, including the reduction of import tariffs on vehicles and durables. These, in addition to an accommodative labour environment, fuelled a 16.0% jump in domestic private consumption last year, surpassing our earlier estimate of 12.5%. This had in turn accelerated the inflation rate to 6.7%, with an uptrend that had prompted policymakers to raise interest rates twice by April.


Personal loans and loans for consumer durables soared a respective 40% and 100% in 1Q 2012. However, their share of total loans remained unchanged, indicating that the lofty growth rates are solely due to an overall improvement in the domestic economy, rather than any significant shift toward consumerism. In the first 7 months this year, the growth of M2 far outpaced that of M1, by 20.7% y-o-y to 4.2%. This implies that if there is indeed such a shift in consumerism, it has been to the opposite direction of saving.


Due to a general slowdown in growth, we expect private expenditure to decelerate to 8.7% in 2012. Going forward, we expect to see the tight monetary policy spill over from this year into the next due to a delayed transmission mechanism, alongside continued external weaknesses that will further retard growth to 8.0% in 2013.


Public Consumption


To tame a burgeoning deficit, fiscal consolidation should see public consumption expand only 2.9% in 2012. As of July, the government had spent 62.7% of its budget allocation for recurrent expenses, with the bulk of the increase going to emoluments. We expect a reduction in expenses for 2H 2012, due to further consolidation as part of the terms agreed with the IMF for its USD2.6 billion loan. The budget for 2013 is reportedly 13.5% larger, with a considerable portion going to the Ministry of Defence and Urban Development. While the demarcation between actual defence spending and infrastructural development remains unclear, it is understood that the defence budget must remain large to repay instalments on arms purchases made during the war. Although the Education Ministry will also receive a welcome injection of funds, up 14% from the previous year, it is also unclear if the budget will be spent on infrastructure. RAM Economics expects public consumption to expand 2.2% in 2012, picking up to 5.1% in 2013.


Investment


Inflows of foreign direct investment ("FDI") have been encouraging, climbing 13.3% y-o-y in the first 4 months of 2012. While this has been the case since the cessation of the civil war, investment levels have only just begun approaching pre-cessation levels, which had only collapsed at the peak of the fighting. Substantial investment is noted in infrastructural rebuilding efforts, particularly by the government of China. Unlike loans from multilateral agencies, those from China come without strict conditions. The better terms and faster turnaround have led to an influx of Chinese-led projects worth over USD4 billion and due to be completed by 2015, mainly in transport and energy infrastructure.


Tourism, traditionally a strong growth area for the economy, is still expected to expand given the government’s announced development goals for the sector. As one of the few sectors permitting full foreign ownership of assets, it is also expected to drive FDI inflows, although this may yet be tempered by the hastily approved Revival of Underperforming Enterprises and Underutilised Assets Act. The colloquially dubbed "Expropriation Act" may undermine previous reformist measures, with a particular body, i.e. American government agency Overseas Private Investment Corporation, reporting that the Act has essentially added a 2%-5% premium on political risk insurance on loans for projects in the country. Despite the setback, we expect the Chinese angle to dominate investment in 2012 and expand 8.0%, followed by a slight slowdown to 7.6% next year due to investor concerns over regressive regulations.


External Trade


Although exports managed to outperform expectations last year, the downtrend has been evident since exports peaked in May 2011. The EU, Sri Lanka’s primary export destination by far, has been mired in a downward spiral that has seen its demand for external goods dwindling drastically. Part of the decline in European demand may also be attributed to the removal of the Generalised System of Preferences Plus scheme, a tax concession. Of even greater concern is the apparent dependence on Europe; in spite of its decline, the EU’s share of exports has not budged from a third of total Sri Lankan exports, indicating that the domestic economy has yet to find a suitable alternative market for its products. The relaxing of the CBSL’s intervention in the foreign-exchange market has seen the rupee depreciate against the US dollar, although we expect it to gradually appreciate again due to easing measures in the advanced economies, which will further hamper exports.


Imports are anticipated to remain fairly robust on the back of persistent domestic demand for imported consumer goods. The CBSL implemented initiatives to curb import demand, contracting the import of consumer and intermediate goods by 20.9% y-o-y and 27.4% y-o-y in July 2012. Nonetheless, the correction in the rupee exchange rate may dampen the effects of those policies. The contraction in investment goods in June and July is a reversal in trend and signals a possible decline in future investment activity.


As such, we expect exports to post a slight growth of 2.2% this year, followed by clearer resolution of the global crisis that will lift exports 3.7% in 2013. Imports should plunge following the excessive growth of 32.7% in 2011 to 6.7% in 2012, before recovering to 7.2% in 2013 based on healthier overall growth.


Agriculture & Fishing


A drought, by some reports the worst since 1992, has been throttling tea output in Sri Lanka, forcing some factories to shut down amid low intake of leaves. Although rainfall in May provided some brief respite, the dry season has persisted into September, wreaking havoc on the country’s food supply. Despite tea output falling 4.3%, the overall growth of the agriculture sector was fairly strong in 1H 2012, thanks to the healthy growth of other crops. In spite of reports of the devastation of paddy fields in the North Central and Eastern regions, paddy output surged 35.5% in the same period, underpinned by the low-base effect brought on by floods at the start of 2011. At the same time, fishing also increased 9.7%.


We estimate that the drought is likely to bring agriculture growth down to 1.6% this year under the base-case scenario, decelerating further to 1.2% in 2013 as the government attempts to increase the sector’s value addition by reducing reliance on the export of raw commodities.


Industry


The drought has also affected the electricity, gas and water sector. Meagre rainfall has hit the country’s hydro-powered generation particularly hard, with water inflows reportedly at their lowest levels in 2 decades. Increased capacity in the form of new hydro plants has been for naught, and the country has had to cut power for the first time in 10 years, after the failure of a new coal plant.


Largely represented by the export-oriented textiles and garment industries, the manufacturing sector posted a 6.5% growth in 1H 2012, driven by the strong uptrend in private consumption. However, waning demand in its major export markets, i.e. the EU and the US, along with a less-than-competitive labour market, has caused a decline in manufacturing output and a loss in attractiveness relative to other low-cost peers such as India, Bangladesh and Cambodia. The government has offered a number of incentives for investments aimed at modernising the ailing local textile industry, but the efficacy of such programmes remains to be seen.


The construction sector stands out as the success story for the industrial sector, expanding 17.9% in 1H 2012 on the back of sustained rebuilding and capacity-building efforts. The focus remains on transportation and ports via large-scale government-to-government deals, particularly with China. The higher interest rates are unlikely to deter construction, as private-sector participation in large-scale projects are limited by a restrictive public-private partnership framework. FDI in the tourism sector, including the construction of a USD500 million mall and a USD450 million Sheraton hotel, are notable examples of the continued expansion of this sub-sector. Against this backdrop, we expect the industrial sector’s growth to moderate to 6.9% in 2012, and 6.8% in 2013.


Services


Since 2009, the Sri Lankan tourism sector has been booming, achieving impressive growth in tourist arrivals and foreign-exchange earnings and proving resilient against external headwinds. Income from hotels and restaurants has been rising over 20% y-o-y each quarter since 3Q 2009. Given the spillover effects on the general population, the government has lofty development goals for this sector. The cessation of fighting and the country’s well-preserved heritage sites have helped spur tourism, but the uptrend has moderated of late, owing to lack of sufficient accommodation and a shortage of trained personnel. The government’s target of USD400 million in FDI inflows bodes well for this sector.


The improvement in the general economic well-being of the population and a thriving consumer culture have been a boon for the wholesale and retail sector, which expanded 5.3% y-o-y in 1H 2012. The favourable labour market and elevated consumer demand should continue lifting this sector, along with the supporting financial segment, which has avoided the repercussions from the CBSL’s tightening policies. Loan applications are at elevated levels and the debt market is expected to remain robust amid the required financing for capital investments. Overall, services should expand 7.2% in 2012 before rising further to 8.2% in 2013, as a clearer market outlook alleviates general concerns and reticence.


Inflation rate


Inflation, as measured by the Colombo Consumer Price Index ("CCPI"), increased at a quicker pace of 7.0% in the first three quarters of 2012. Rising food and fuel prices accelerated the CCPI’s growth momentum. This was largely due to supply concerns (both global and domestic), increased global liquidity amid the accommodative monetary policies of the advanced economies and a weaker rupee. As most of these conditions are likely to persist through the remainder of the year, the CCPI is anticipated to register a growth of 7.4% for 2012 (2011: 6.7%).


Going forward, Sri Lanka’s inflation rate is expected to ease as demand for loans will decelerate to a more sustainable pace, in response to the slow recovery of the global economy, domestic macro-prudential measures and the upward adjustment of interest rates. Nevertheless, as a substantial proportion (77%) of the CCPI is represented by food and fuel price indices, Sri Lanka’s overall price levels are highly susceptible to movements in global commodity prices and domestic supply conditions.


Interest rate


This year, the CCBL increased its key policy rate – the reverse repurchase rate ("RRR") – by 75 basis points to 7.75% to date. These upward revisions of the policy rate represent the first changes in Sri Lanka’s benchmark interest rate since January 2011. The tightening of the interest-rate policy had been in response to the constant acceleration in private-sector loan growth, which peaked at 35% in March 2012, and had been deemed unsustainable by Sri Lanka’s main financial regulator.


Despite the expected slower domestic loan growth next year, the CBSL is unlikely to adjust its current accommodative policy stance as the uncertainties looming over the global recovery may weigh on Sri Lanka’s near-term growth prospects. That said, if domestic loan growth continues at the present pace, the possibility of further monetary-policy tightening will be heightened as the CBSL has shown that it will maintain domestic financial stability to ensure the sustainability of the country’s medium-term growth.


Exchange rate


By end-2011, the CBSL had largely ceased its intervention in the foreign-exchange market. This had allowed the rupee a certain degree of flexibility while giving the CBSL some space to combat inflation in the interest of macroeconomic stability. The relaxation of exchange-rate controls had led to a 16.3% depreciation for the rupee in 1H 2012. In the following months, the rupee had stabilised amid the easing of advanced economies’ monetary policies. The rupee is expected to appreciate to an average USD/LKR rate of 128 for the full year.


The volatile global economic landscape will likely translate into a weak near-term appreciation for the rupee; the currency is expected to appreciate 1%-3% on average to a range of USD/LKR 125-130 in 2013. Over the longer term, the rupee is envisaged to appreciate as tourism revenue and capital inflows counter Sri Lanka’s persistent negative trade balance.


Medium-term growth


Sri Lanka is expected to post a medium-term average growth of 6.0%-6.5% for the remainder of this decade. This expectation is primarily based on a favourable demographic profile, where the young-age dependency ratio – the ratio of the population aged under 15 years against those aged between 15 and 64 – stands at nearly 40%. This ensures Sri Lanka’s medium-term consumption and labour-supply growth, thus providing an underlying basis for economic expansion. The various fiscal programmes to restructure the workforce following the civil war and the continuous growth in tertiary-education enrolment encourage growth as they facilitate better allocation of human resources, which would in turn expand Sri Lanka’s production possibility frontier. Furthermore, the continuous inflow of capital, particularly from large emerging economies, will provide the means for Sri Lanka to accelerate its growth potential in the coming years.


The primary risk to this growth estimate stems from the Sri Lankan regulatory environment. Although the World Bank has noted that the country’s business environment has indeed improved, there is considerable scope for further progress. This is especially true with regard to the bureaucratic or regulatory costs involved in obtaining construction permits, registering property, paying taxes and enforcing contracts. Enhancing the role of the private sector in Sri Lanka’s development provides a certain degree of dynamism that is essential for more sustainable longer-term growth.


Fiscal balance


Sri Lanka’s resilient post-civil war economic growth has been the main driver in the improvement of the nation’s fiscal balance, which showed a smaller deficit of 7.0% in 2011 (2009: 9.9% deficit). The government this trend to continue in 2012, on the back of higher tax revenue. Likewise, Sri Lanka’s sovereign debt load has moderated since 2004, as nominal GDP growth during this period has consistently outpaced the government’s primary fiscal deficit.


However, the risks to Sri Lanka’s medium-term fiscal performance are substantial. Slower economic growth – as a result of a more subdued global economy and the CBSL’s tightening stance – will dampen tax revenue. The higher interest rate set by the CBSL and the recent depreciation of the rupee will, likewise, adversely affect the overall fiscal balance through higher interest payments. Volatile global commodity prices – particularly with regard to fuel prices – will likely burden large state-owned energy enterprises, which can pose risk to the sovereign’s finances in the future.


That said, the recent efforts of the authorities to improve domestic tax administration – especially with regard to the Value-Added Tax – are expected to enhance the sovereign’s revenue profile. At 14.5% of GDP in 2011, Sri Lanka’s version of this tax is relatively low compared to most other economies.


External balance


In 2011, Sri Lanka’s current-account deficit widened to LKR511.1 billion or 7.8% of GDP, thanks to a larger trade deficit. This was due to higher global commodity prices and the robust domestic economic growth that had driven demand for imports. Sri Lankacurrent-account deficit is generally moderated by the surplus in the services account, which is generally represented by tourism revenue and has seen larger inflows in recent years. The positive net transfers chiefly represent remittances of funds from the Sri Lankan worker diaspora, which is roughly equivalent to 3 million people or 15.2% of the country’s population. The substantial emigrant population is expected to increase in the near term due to the sizeable labour demand and wage differentials in the expanding economies of the Middle East and East Asia. We note that Sri Lanka’s capital and financial account benefits from long-term capital inflows. These inflows originate from large, emerging economies and participate heavily in the country’s major infrastructure projects. These flows are expected to accelerate after the relaxation of the CBSL’s foreign-exchange controls and the longer-term growth potential of the domestic economy.


Nevertheless, Sri Lanka’s external balance tends to be very volatile as it is a net energy importer. There is substantial risk of global energy supply shocks to the country’s balance of payments; this may diminish the effectiveness of the CBSL’s monetary policy tools in reducing short-term macroeconomic volatility.


 
 
 
 
 
 
 
 
 
 
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