By Shehan Bartholomeuz, LOLC Securities Ltd.
Sri Lanka passed the ADB’s lower middle income threshold guideline of US$ 2,000 per capita in 2008 and in 2010 IMF promoted Sri Lanka from the list of Poverty Reduction and Growth Trust (PRGT) eligible countries to middle income emerging market status. The
country continued to record fast paced economic growth on the post war benefits kicking off the economy from a low base.
The Central Bank of Sri Lanka (CBSL) has set the economic target of passing US$ 4,000 per capita by 2016 to move the economy into upper middle income range as defined by the World Bank. Whilst hitting US$ 4,000 target by 2016 itself is quite a challenging target itself with requirement over continued 8+% GDP growth over the next three years, the real challenge will be to transform a middle income earning country to high income country with per capita income passing US$ 12,000 levels.
The ‘middle income trap’ economic phenomena has affected many countries which has seen smoother transition from US$ 2,000 per capita income economy to US$ 4,000 per capita economy but after that the economies have shifted into slower growth phase. To put it in perspective, out of the 101 middle income economies that existed in 1960, only 13 countries have graduated to high income status by 2008 according to a World Bank report. Therefore a challenge is ahead for Sri Lanka, and the Government has realised it and has set policies looking ahead from just reaching middle income status from post war benefits to guide the economy through potential middle income issues to set the path for the economy towards a high income economy in the future.
Policymakers have identified the potential of making Sri Lanka the regional hub of South Asia with its geographical location and other resources, which will help the Government achieve long-term GDP growth targets for the economy. Some of the key sectors the Government is looking at driving its hub status are tourism, energy, commerce and transportation.
Sri Lanka is an island with area of 65,610km2 ,which has so much diversity for a small island in terms of pristine beaches, beautiful hill country, plenty of flora and fauna, heritage sites with a history spanning over 2,500 years and is a friendly nation known for its hospitality. These factors make Sri Lanka an ideal gateway for a holiday and it has been widely recognised by international publications such as National Geographic, Lonely Planet and New York Times. After the end of war the tourism industry has taken off rapidly due to it being an undiscovered destination marred by a 30-year-long war and for the reason mentioned above (Chart 2).
With the strong bullish picture, the Government of Sri Lanka (GoSL) has started to put more attention on the tourism sector. Accordingly it has set an ambitious target of tourism receipt of US$ 2.75 billion and number of arrivals of 2.5 million by 2016. But it will require more than 25% growth of tourist arrival numbers next few years and it is increasingly becoming a difficult target
considering the drop in year on year growth rate since 2010 (Chart 2).
The fact that the country has so much diversity itself will not be enough to maintain sustainable rapid growth as challenges have started to become apparent such as higher cost structure (increased finance cost, inflation, energy cost, etc.), changing demography of the tourist (shift from being a predominantly Western tourist driven to east traveller, for example there will be lesser demand for beaches from east traveller), challenges in increasing the spend for a tourist, high labour turnover, lack of room capacity, etc.
The most apparent challenge in the tourism industry is in the supply side in terms of hotel rooms available to cater for 2.5 million tourists by 2016. To cater to the demand it is estimated around 45,000 rooms will be required by 2016. We estimate current room portfolio in the country to stand around 27,000 (based on Sri Lanka Tourism Development Authority – SLTDA approved hotel rooms and hotel booking website www.agoda.com). Therefore approximately another 18,000 rooms need to be added by 2016 to cater to the growing demand. The hotel industry investors led by international players have identified the potential and have started several projects to reap the potential of a booming industry (Table 1).
Studies indicate that there is strong correlation of a country’s power supply and economic growth. Gross generation in 2012 stood at 11,801GWh and it is projected by 2020 electricity demand to be 17,489GWh. Accordingly continuous capacity expansion is required and more than 100MW of annual addition is estimated to be required to meet the demand. Sri Lanka’s current electricity generation capacity stands at 3,312MW and the largest source of generation is diesel thermal which accounts for 59% of the generation.
The GoSL’s energy expansion strategy has shifted more towards coal with its lower cost of production and in the Ceylon Electricity Board’s ‘Generation Expansion Plan 2011-2025,’ out of capacity additions till 2025, 88% will be coal-based capacity additions. On the other hand the Government has also realised the importance of diversification, especially as it has increasingly become dependent on fossil fuel-based energy sources, which generally has strong correlations with each other in prices. Accordingly the Government is promoting diversification into other sources led by renewable energy sources.
In the country’s strategy of becoming an energy hub in the region, Sri Lanka has been evaluating potential to find hydrocarbon energy sources within the country. Sri Lanka has found potential sources of oil/gas in west and north coast waters. Cairn Lanka has discovered hydrocarbon in two of four exploration wells drilled in deep water off the west coast. Commercial viability is yet to be established and Sri Lankan authority is expected to award the exploration licenses for potential 13 blocks and award the six blocks for the seismic studies.
Sri Lanka’s geographical location, presence of increasing number of financial professionals and stronger regulatory framework creates
a strong case for the country to be the capital market hub in the region. The Government has opened up the economy for foreign investors and at the same time has continuously strengthened the systems and regulations to build the confidence of the investors. In the last couple of years, the country has seen the highest net portfolio investments to Colombo Stock Exchange and highest FDI. But still the country needs to do significant improvements in the capital market development and direction has been set by the authorities to meet development targets. Furthermore the country’s fast development in ports and tourism will provide catalysts for the commercial sector development.
Sri Lanka, the South Asian island, is located at a strategic location connecting the East-West trading line. Especially if we consider the East-West shipping line, one of the busiest shipping line in the world, it lies only about 10 nautical miles from southern port of Hambantota. If we also consider the fact that the balance of the world’s economic power is shifting towards the East, Sri Lanka’s case for a strategic location for world trade is further justified. Therefore the Government has invested considerably in the transportation sector with foreign assistance led by Chinese investments. Accordingly, key projects are listed below:
nColombo Port Expansion: 6.8km breakwater – One of the longest breakwaters in the world, a US$ 400 m project using ADB finance. (ADB – US$ 300 m, GoSL – US$ 100 m)
- Colombo Port Expansion: Increase Colombo port’s current capacity of four million TEUs per annum to 11.2 million per annum by 2020 –Three terminals to be constructed and the Colombo International Container Terminal is being built with investment of US$ 500 million (China Merchants Holdings International – 85%; GoSL – 15%). The new terminal is the only port in the South Asian region with a deep-water terminal that can accommodate larger 18,000 TEU container ships.
- Hambantota Port –The first phase is underway with investment of USD 360 million (Ex-Im Bank of the China – 85%, GoSL – 15%). Hambantota port lies close to the East-West shipping line and the strategy is to attract at least 20% of the shipping traffic.
- The second international airport at Mattala, Hambantota was opened this year and the investment is estimated to be about US$ 200 million.
- There has been significant infrastructure development in terms of road network improving the mobility within the country. Most of the rural roads have been concreted, two expressways have completed and there are several projects in the pipeline which further improve the road network of the country considerably.
Sri Lankan economy took off recording more than 8% growths for two consecutive years after the war end and CBSL continued to support growth by relaxing the interest rates by cutting the policy rates by 350 basis points from 2009 to beginning of 2011. But with relaxed credit environment, imports increased rapidly putting pressure on the external sector. By end of 2011 the trade deficit shot up, with the trade deficit to GDP ratio hitting 16.9% from 9.6% in 2010 raising balance of payment concerns. CBSL had to step into stabilise the environment and put measures to control the credit and external account to curb down imports. The measures resulted in the economy slowing down considerably in 2012, achieving a slower real GDP growth of 6.4%. By the end of 2012 the external sector had stabilised considerably with stronger reserves, controlled inflation and stable currency outlook. Therefore CBSL was in a position to implement policy measures to revamp the slowing down economy. Thereby CBSL has cut down the policy rates by 125 basis points since December 2012. We believe the recovery will be bit sticky with the slowdown of business activity, but CBSL is confident of hitting targeted 7.5% GDP growth for 2013.
The country’s revival from policy decisions also may be restricted from the fiscal front. On the funding side debt to GDP ratio has ease down considerably since the early 2000s 100+% to about 80%, but still the ratio is comparatively high for an emerging market. It is especially a point of concern as Sri Lanka moving towards middle income country it will find it difficult to get loans on concessional bilateral agreements. Therefore the proportion of non-concessional and commercial loans of the external debt has increased significantly in recent times. Hence while the Government needs to spend to achieve its growth ambition it will need to keep eye on the increased cost of funding. Even though the fiscal deficit has reduced from 9.9% in 2010 to 6.4% in 2012, the Government further needs to strengthen the expenditure and revenue sides to further stabilise the fiscal front.
In summary, Sri Lanka has strong growth prospects with its immense potential to become an economic hub of the region. But there will be challenges for its journey to become an upper middle income country and beyond. We believe that with the proper policy framework, continued flow of investments to the country and improved innovation, the country can achieve sustainable high growth rates to achieve its long-term growth targets.