Sri Lanka’s shrinking payoff

Friday, 31 December 2010 01:04 - - {{hitsCtrl.values.hits}}

Dow Jones: Sri Lanka’s post-war economic boom is only just beginning. Have investors already missed the boat?

In the 19 months since the nation’s civil war ended, stock prices are up nearly 250% and the rupee up 6%. Government debt is also in high demand: The difference between yields on a Sri Lankan dollar-denominated bond due in 2012 and similar U.S. Treasury’s is just 3.5 percentage points, data from Barclays Capital show. A year ago, that was spread closer to 6%.

The potential here goes well beyond a boost in tourism. Sri Lanka’s location within East-to-West shipping lanes is promising, and large areas of farmland and coastline in the northeast can be developed now that fighting has ended. The government, meanwhile, recently implemented tax cuts and other reforms aimed at boosting foreign investment. Adjusted for inflation, economic growth could be close to 8% this year, up from an average of 5% in the prior decade.

Bond market strategists are now expecting Sri Lanka’s credit rating to be revised upward next year. Investors, though, have already taken things a step further: Moody’s says the market-implied rating on Sri Lanka’s sovereign debt is Ba1, three notches above where the agency currently rates the country and only one level below investment grade.

But Sri Lanka is still far from investment grade, in large part because of government debt racked up over three decades of fighting. This debt stood at a whopping 86% of gross domestic product last year. On “debt affordability” Moody’s rates Sri Lanka higher only than Lebanon and Jamaica. Rising commodity and food prices could make efforts to cut this debt tougher if domestic investors demand the government pay higher yields to compensate for inflation. About 40% of spending in next year’s budget is allocated for interest payments.

Stocks face a possible headwind too. As many as 60 companies could conduct initial public offerings next year, says Yolan Seimon, head of research at John Keells Stock Brokers in Colombo. Many of these deals will be small, but the rush is still substantial given that there are only 240 companies currently listed. Anyway, Seimon says, with stocks now trading at 14.9 times expected earnings, price gains will likely average 20% to 25% a year, tracking profit growth.

Investors turning up now, seeking the triple-digit returns of recent years, will find that ship has sailed.