Key insights from Acuity Stockbrokers’ Economic Review

Sri Lanka – isle of opportunity

A year after Sri Lanka gained its second lease of independence and peace has prevailed within its borders thus far, what has Sri Lanka achieved and what next?

May 2009 ushered in a new era for Sri Lanka with more resources for productivity enhancement and development; a larger workforce, serene coastlines including a natural harbour that were inaccessible by war, more land to develop and cultivate, connectivity of people, land and infrastructure and more so an undivided focus on growth and development.

Macro Economic Review and Analysis

2010 Q2 GDP growth recorded an 8.5% increase and is well on track to meet year-end target growth levels with 1H 2010 recording a 7.8% growth compared to 1H 2009. We estimate GDP growth to be about 7.2% for 2010.

The Q2 growth of 8.5% is the highest recorded since 2002, however from a lower base of Rs. 585.5bn GDP recorded in Q2 2009. Agriculture sector recorded a 5.1% growth as against Q2 2009 amounting to 11.9% of GDP while the industrial sector grew by 9.2% (28.1% of GDP) and services sector recorded a growth of 8.8% accounting for 60% of GDP.

Agriculture sector

This sector showed a 5.1 % growth during the Q2 of 2010 as against the growth of 5.0 % during the same quarter of the previous year. Tea production recorded a 7% growth for Q2 2010 as against a contraction of 7.0 % for the Q2 2009 owing to favourable weather conditions and better market prices. Rubber production grew by 3.9 % for this quarter as against the 4.5 % the same quarter of the last year, mainly due to the increase in average price of Rubber (at Colombo auction) which rose from Rs.167.22 per Kg in Q2 2009 to Rs. 395.09 per Kg in Q2 2010. Fishing industry recorded an 18.3 % growth in Q2 2010 with both the Inland and Marine fishing improving during 2010.

Industry sector

The manufacturing sector which is the largest contributor grew by 8.9 % in Q2 of 2010. The growth rate of Gem mining in the Q2 2010 recorded an 8.5 % due to increase in the export value of precious stones and semi precious stones increasing by 11.2 %. The factory industry grew by 9.2 %, supported by growths in textile, apparel and leather products by 7.9 %, chemicals, petroleum, coal, rubber and plastics products grew by 16.5 % and non-metallic products by 15.9 %.

Construction sector indicated a 9.3 % growth rate for the Q2 of 2010 compared with the growth of 5.4 % for the same quarter last year.

Service sector

This sector boasts an 8.8% growth rate in Q2 2010 due to the recovery of its major sub sectors i.e. Wholesale & retail trade, Hotels & restaurants and Transport & communication. The growth rate in the same quarter of 2009 however, was only 1.2 %.

Tourists arrivals increased from 81,027 in the Q2 2009 to 118,243 in the Q2 2010 indicating a 45.9 % increase. Tourist earnings increased by 60.9 % and room occupancy rate increased from 35.5% in Q2 2009 to 50.8% in Q2 2010.

Transport and communication sector indicated a 12.9 % growth in the Q2 of 2010 as against that of

5.7 % growth in the same quarter of last year.

Cargo handling and Ports & civil aviation recorded 15.9 % growth in this quarter. Banking, Insurance & Real estate sector grew by 8.5 % in the Q2 2010 against the growth rate of 5.4 % in the same quarter of 2009.

Outlook

With accessibility of new land and fishing territory in the North and East the Agriculture sector which accounts for 32.6% of the employed population is expected to flourish adding extra output to GDP. Post war development and construction together with infrastructure expansion will boost industrial activity and drive demand in the sector while the tourism boom and related development to manage the demand together with the port development targets and escalation in the Services sector revenues. The macro economic outlook for Sri Lanka is very promising and is expected to record a GDP growth of 7% for 2010.

The medium term growth targets of the Government range from 7% to 8% with the required investment of about 30% of GDP to achieve such a growth expected to derive mainly from domestic savings from the Government and Private sector and considerable inflows of foreign resources.

Key growth sectors

Tourism,   ports and aviation, oil exploration, construction, power and energy have been identified as some of the key sectors for development with growth potential in the Sri Lankan economy.

Travel and Tourism

The sector is one of the early beneficiaries of the post war recovery with cumulative tourist arrivals for

January to July 2010 recording a 49% increase as against the same period in 2009, the highest growth levels recorded in the Asian region according to UNWTO statistics for 1H 2010.

Tourist arrivals for 2009 recorded a 2.1% growth year on year despite a sharp decline during early

2009 at an average rate of 18.3%, the latter seven months of 2009 recorded a significant increase in arrivals with the travel warnings issued by many countries being relaxed with the end of the 30 year conflict in May 2009.

Average occupancy rate for 2009 has been 48.4% however at present the occupancy rates have improved to around 85% while the ARRs have also improved helping the sector to report a turnaround in profitability during 1H 2010.

Earnings from tourism for January to July 2010 records a 68.8% increase as against the same period in 2009 to reach US$ 301mn. Total earnings from tourism for 2009 amounted to US$ 350mn recording a marginal increase of 2.2% as against 2008.

Presently most of the hotel groups are refurbishing their existing properties and undertaking expansion plans to meet future challenges and growth. Occupancy levels and room rates are significantly higher as compared to the previous year. The coastal cities of the Eastern Province, Arugam Bay, Passekudah and

Trincomalee are being promoted as recreational centres and Kalpitiya and other selected inland islands are also targeted for development into tourist resorts.

Outlook

Total arrivals for 2010 expected to reach 600,000 tourists with earnings expected to reach US$ 490mn.

Most hotel groups are refurbishing existing properties, initiating expansion plans and investing in building new hotels to accommodate the growing demand. The current room capacity of 14,600 is expected to expand rapidly with 2,000 to 3,000 rooms being added in by end 2010, targeting a total room capacity of 25,000+ during a six year span to cater to the 2.5mn tourist arrivals targeted for 2016.

Power and Energy

Electricity generation in total has declined by 0.2% in 2009 to 9,882 GWh mainly due to the slowdown in the industrial sector. The CEB has generated 55% of the electricity generation while the private power produces accounted for 45% of the generation. Total installed capacity in the country has increased by

1.4% in 2009 to reach 2,683MW. As per latest statistics from CBSL 86% of households in Sri Lanka have electricity and the per capita electricity consumption stands at 412.8 kWh/person. At present, USD1.6bn is being spent on new hydro and coal-based power plants, which are likely to increase generation capacity by 32% when fully operational.

The implementation of low cost power generation projects, implementation of a realistic and flexible pricing policy and exploring possibilities of transforming high cost thermal power plants to run on low cost fuel such as liquid natural gas are being considered in order to improve the financial situation of the CEB, which currently exerts pressure on macroeconomic management.

Oil exploration in the Mannar basin which extends to the north west of the country has been identified as a potential oil and gas source and in 2007 the Ministry of Petroleum and Petroleum Resources Development held its first licensing round for oil exploration where Cairn India Limited was awarded with the contract for oil exploration one block. The Government of Sri Lanka signed a petroleum resources agreement with Cairn Lanka Private Limited (CLPL), the local subsidiary of Cairn India Limited in July 2008 and recently awarded another block to China’s CNOOC. CLPL has taken steps to procure 1,450 sq km of 3D (Three Dimensional) seismic data, which is to be completed in 2010. CLPL has also called for bids to hire drilling rigs and logistic services to commence exploratory drilling in early 2011. The Ministry of Petroleum and Petroleum Resources Development plans to conduct the second licensing round for oil exploration in the near future. A few blocks from the Mannar Basin as well as some blocks from the more prospective Cauvery Basin and the southern offshore basin, would be available for competitive bidding.

Ports

Sri Lanka’s strategic geographical location within close proximity to the east-west maritime route used for international trade makes it a potential hub with minimum diversion time. The growing trade in the region and the increased level of integration with the rest of the world create the demand for enhanced port facilities. Development of port infrastructure has been given priority during recent times with the SLPA incurring a total capital expenditure of 9.3bn on port development projects during 2009 with several PPP projects also in progress. New ports in Hambantota, Colombo and Oluvil are being built while enhanced capacities of existing ports in Colombo, Galle and Kankesanthurai are in varying stages of completion and are expected to substantially boost employment and revenues.

Although there has been a substantial improvement in handling capacity in recent years to around 3.7 million Twenty Foot Equivalent Container Units (TEUs) per annum, it continues to be lower than those of the more efficiently operating competitors. Thus, it is vital that Sri Lanka’s ports are developed and

modernised through the infusion of new technology to meet the growing demand and cater to the larger vessels that sail on the international east-west maritime route.

Public-Private Partnerships (PPP)

PPPs have been identified as a mode of implementing infrastructure projects to attract private sector investment in development and to ease the pressure on Government budget.

The following projects within the BOI are now being structured on PPP basis.

n Development of Knowledge City at Henegama (Gampaha District) (US$ 100mn)

nAugmentation of Water and Wastewater Facility at the Seethawaka Industrial Park (US$ 7.5mn)

nDevelopment of Information Technology Park at Malabe (US$ 80.45mn)

nDevelopment of a Mass Rapid Transport (MRT) System in Colombo Metropolitan Area (US$ 1,000mn)

nDevelopment of Textile Manufacturing Zone/Industrial Park at Perth Estate, Horana (US$ 50mn)

nConstruction of a Mixed Development Project at the Service Area of Kandy Industrial Park

The following projects initiated by other government institutions are presently being facilitated by the PPP unit.

nRevival of Embilipitiya Paper Mill (US$ 100mn)

n Colombo Kandy Expressway (US$ 1050mn)

n Expansion of generation capacity of power stations

n Laying of fibre optic cable for Sri Lanka Railways (US$ 50mn)

n Transworks Towers at Fort

nColombo Medical Faculty – Expansion Project (US$ 50mn)

nWaste Management Authority (W/P) Project (US$ 100mn)

nDevelopment of modern bus passenger terminal at Bastian Mawatha (US$ 50mn)

n Housing scheme for Government officials at Keppitipola Mawatha, Colombo 7 (US$ 100mn)

nSouth Harbour Terminal Project (Bids closed) (US$ 350mn)

nMadhu Tourism Project- Northern Province (US$ 150mn)

Inflation

Inflation rate as measured by the CCPI has continued to ease from a peak of 28.2% in June 2008 with the revisions in monetary policy and favourable supply and demand conditions. The current annual average inflation as at September 2010 stands at 5.0%, increasing from 4.5% recorded in August, while on a point to point basis for September it recorded a 5.8% increase.

We expect inflation to average at around 6% in 2010 with improved food supply from North and East and the international commodity inflation downturn leading to lower cost of imported goods. Food and non alcoholic beverages sub index has a weighting of 46.7% in the CCPI and any adverse price effects will have an immediate impact on inflation. The risk to inflationary pressure is expected to be contained through reserve money targets being increased and the increase in credit growth curtailing excess liquidity in the market.

External Sector

The overall performance of the external sector was adversely affected in 2009 due to the global financial and economic downturn which curtailed financial inflows and also resulted in the withdrawal of short term funds in Government securities. However, commencing from the latter half of 2009 the positive outlook and increased investor confidence in the economy aided a recovery. The trade deficit contracted by 47.8% in 2009 owing to the greater decline in import expenditure than export earning reduction.

The cumulative earnings from exports and expenditure on imports have increased by 14% and 42%, respectively, during the first six months of 2010, resulting in an expansion in the trade deficit to US $ 2,844 mn.

During the first half of 2010, workers’ remittances increased by 13.5% over 1H 2009 to US$ 1,820mn. Gross official reserves, with and without Asian Clearing Union (ACU) funds, but including domestically arranged swaps, increased to US$ 6,013mn and US$ 5,731mn, respectively, by end June 2010. Based on the previous 12 months average monthly import expenditure of US$ 1,001mn, the gross official reserves had an import expenditure cover of 5.7 months.

LKR:USD - stable outlook

The LKR depreciation against the USD was at 1.09% in 2009 with foreign exchange reserve position improving during the second half of the year. The IMF standby facility and special SDR allocation received increased investments in government securities. The total value of interbank forex transactions in 2009 decreased to US$ 11bn as against US$ 14bn in 2008. As FX reserve accumulation has neared the CBSL target of USD6bn, the focus of reserve accumulation has eased and the LKR has gained strength. Given the strong prospects for more capital inflows with the IMF releasing the fourth tranche of US$ 212.5mn under the US$ 2.6bn standby arrangement and the soaring demand for the current US$ 1bn sovereign bond indicating positive investor sentiments on Sri Lanka, this trend should continue in the medium term. The Central Bank has also outlined a policy of gradual appreciation in the medium term. Therefore the LKR is expected to strengthen against the USD further during 2010.

Policy rates and Money market rates decline

The Central Bank has continued to revise the repo and reverse repo rates downward on the back of lower inflation levels, giving impetus to economic activity. The last review in August 2010 kept the repo rate unchanged at 7.25% while lowering reverse repo rate by 50bps to 9% narrowing the spread. Lending rates have continued to decline with the commercial banks’ WAPLR which was as high as 20% two years ago to 10.4% at present. Credit growth also indicates a pick up to 6.2% yoy in June 2010. The general economic stability, monetary policy encouraging economic activity and improved real incomes should continue to support credit demand in H2.

Foreign Direct Investments

Foreign Direct Investments (FDI) during 2009 decreased by 32.4% to US$ 601mn after the record high of US$ 889mnin 2008, while BOI estimates 2009 levels of FDIs for current year as well. Telecommunications and the power and energy sector have attracted the most amount of funds during 2009 amounting to US$ 296mn and US$ 67.7mn. FDI for 1H 2010 have not been as strong as 2009 recording a decline from US$ 250mn in 2009 to US$ 200mn for 1h 2010.

Government debt increased by 4.5 yoy as at end June 2010

The overall budget deficit in 2009 increased to 9.8% of GDP and 10.2% of GDP (excluding grants) surpassing the targets set by the budget of 5.9% and planned deficit target under an International Monetary Fund (IMF) $2.6 billion standby arrangement of July 2009. Increased expenditure and slow revenue growth together with constraints in raising foreign borrowings led to the government raising funds through the domestic market. The debt to GDP ratio increased to a staggering 86.2% in 2009. Total Government Revenue for 2009 has been Rs. 702.6bn an increase of 7.2% as against 2008. During 1H 2010 Government revenue has recorded a 23% growth as against 1H 2009 to reach Rs.355.4bn. Tax revenue has recorded a 16% growth and account for 87% of total revenue, while current and capital expenditure records a yoy increase of 3.1% to Rs. 576.8bn.Government Debt as at end June 2010 stands at Rs. 4,347.5bn recording a 4.5% increase from the position at year end 2009 and an 11% increase yoy.

Equity Market – 138% y-o-y growth

Market overview

The Colombo bourse has outperformed stock markets around the world recording a year on year growth of 138% and a year to date growth of 111% as measured by the All Share Price Index (ASPI) reaching new heights continuously. Activity levels have improved significantly with daily average turnover increasing to Rs. 2.33bn year to date as against .59bn recorded in 2009.

The positive economic outlook coupled with reduced country risk, strengthening of LKR against USD and declining yield rates of fixed income securities have renewed domestic and foreign investor interest in the stock market. The current market capitalisation stands at Rs. 2.36 trillion, around 46% of GDP recording a gain of 109% year to date.

Strong corporate earnings potential

Corporate earnings for the quarter ended June 2010 resound the initial signs of the post war macro economic recovery in Sri Lanka. Our analysis of 204 counters or 87% of total based on attributable profits of the listed entities indicate a significant turnaround in corporate earnings potential as against the FY2009 which has been a relatively “bad” year coupled with the escalation of combat against the LTTE, global recession, inflationary pressures and other economic constraints.

Attributable profits of the reported entities for Q2 2010 total to Rs. 25.4bn as against Rs. 6.6bn reported for Q2 2009 indicating a 284% growth (68% growth excluding the effect of Dialog’s performance on both quarters).

Key sectors that have contributed to the quarter earnings were Banks, Finance and Insurance amounting to 36% of total while the Food, Beverage and Tobacco sector brought in 14% of profits and Diversified sector 13%. Six key sectors account for 81% of the total earnings generated during Q2 2010 i.e. Banks and Finance, F&B, Diversified, Telecom, Manufacturing and Health Services. The footwear and textile sector has been the only sector reporting losses during Q2 2010 as against Q2 2009 where a cumulative loss of Rs. 8.6bn reported by the Telecom sector (Dialog Rs.7.7bn loss), Hotels and Travels, Power and Energy sector and Motors eroded the profits generated by other sectors weighing down total earnings for the quarter to Rs. 6.6bn.