Economy in transition; safety over acceleration

TKS Securities has come out with its latest update on the economy highlighting some key developments in the first two months of the year as well as their implications. Here are excerpts from the update done by TKS Securities Equity Research Director Danushka Samarasinghe

February 2012, MTD, has been an eventful period in which economic policy and direction of Sri Lanka took a decisive turn. The swiftness of these directional change has taken the market and economic participants by surprise, which was evident with the Colombo bourse shaving off 8.5% (including today) in market capitalisation since beginning February.

Today, following the upward revision of fuel prices, the All Share Price Index (ASPI) lost 2.2% from last Fridays’ close though displaying a moderate recovery at close of trading. The past two weeks brought about marked changes in the interest rate environment, exchange rates and cost structures within the economy.

Having reduced policy rates by 25 bps in January 2011, Sri Lanka held its rates steady for 12 months till the Central Bank revised up the policy rates by 50 bps on 2nd February 2012. The 50 bps spike in policy rates (as opposed to a marginal increase of c.25 bps) was in order to send out a strong signal that market interest rates needs to head north in order to avoid a possible liquidity crisis triggered by sharp credit expansion.

Credit to the private sector which grew by c.33% YoY in 2011 is expected to slow with a near 150-250 bps increase in market interest rates from the current broad average of 14%-15% levels. Given the prevailing status-quo we expect private sector credit growth to be held back at around 17% in 2012.

On 9th February the Central Bank made another mammoth change in its policies with regard to currency management and edged evermore closer to a free float environment. Sri Lanka which practiced a managed float used to frequently intervene in the currency market to enable a de-facto peg with the greenback. With the end of war, inflow of foreign portfolio money, foreign debt and growth in remittances (which is around 8% of GDP) boosted Sri Lanka’s reserves to highest ever levels seen in the past two decades.

However expansionary growth driven economic policies widened the trade deficit to c.17% of GDP in 2011 and raised concern of a BOP crisis. However it is noteworthy that export earnings too grew at plus 22% YoY during 2011 though falling short of bridging the trade gap which was been driven by faster growth in all three major import categories, namely; consumer, intermediary and investment goods. Nevertheless it was satisfactory to witness the imports of investment goods to record the fastest growth amongst the broad sectors, growing at 63.5% YoY to US$4.2 billion (c.23% of total imports) displaying the ability of the economy to record sustainable real growth in future. Petroleum imports grew at 54% YoY and accounted for 22% of total imports displaying the economic vulnerability to external forces, chiefly oil sourcing disruptions from the Middle east. Though non-essential consumer goods imports grew by 72% YoY to US$1.9 billion as at November 2011, we believe this components’ growth would reverse in 2012 and rather cap total growth in imports since it was chiefly driven by tax/import duty cuts on luxury consumer durables.

In our opinion many challenges affected exchange rate management in Sri Lanka, while widening trade deficit was a concern other factors too adversely put pressure on the SL Rupee (though could have been only a short term impetus), balancing strong growth without the luxury of deep pockets proved to be an uphill task while the IMF’s loan of US$2.9 billion brought about a catch-twenty-two situation. The post war Sri Lankan economy recorded 8% GDP growth for two consecutive years and was projected to record similar growth in 2012 as well. However financing this strong growth proved to be difficult given the short fall in FDI’s (which was c.US$700 million in 2011 while we believe it should have been around US$1.6 billion which is approx. 3% of GDP in order to drive healthy economic expansion) and outflow of foreign portfolio money given the market correction and global economic implications. Further external pressure was inserted on the domestic economy, following the trade embargo on Iran, which was the cheapest supplier of crude oil to Sri Lanka while also providing a six months revolving credit facility. Hence going forward, cheap Iranian oil is not available and Sri Lanka has to purchase oil from other suppliers at open market prices which could dwindle the foreign reserves. Having already drawn in US$2.1 billion of the IMF loan facility, the domestic economy is subject to certain conditions with regard to macro-economic health, and therefore not in an ideal position to raise fresh debt from international markets in order to maintain the debt-to-GDP level at the current 82% or lower. Therefore last week the Central Bank had to withdraw from its currency defence policy (which was done in order to create an artificial currency peg) and allow the SL Rupee to float (albeit having mentioned that they would provide quantitative intervention with regard to oil bills) in an attempt to safeguard the foreign reserves which we believe is sufficient to service four months’ worth of imports. With these policy changes it was recently reported in the media that the delayed final tranche of US$800 million IMF loan would be made available in the near future.

Having upped the interest rates and floated the currency within a period of 10 days, the Government of Sri Lanka increased the retail fuel prices on 11 February favouring free market policies. The same government in 2007, initiated the move away from subsidised fuel and made price adjustments according to world market prices. However till February 2012, Sri Lanka adopted a cross-subsidy scenario for its fuel sales where petrol was heavily taxed and sold at higher prices when compared to international markets while Diesel was sold at a discount to international prices. The lower pricing of

Diesel was a legacy policy adopted by many governments since Diesel was the main fuel used in transportation, distribution and power generation in Sri Lanka, hence holding back the fuel price enabled the capping of both consumer and industrial inflation. With the recent most fuel price revision the price of the most basic Diesel fuel was increased by 37% to LKR115/liter (c. US$0.99/liter) and 90 octane petrol by 9% to LKR149/liter (c. US$1.28/liter).

We consider the retail fuel price revision by the government to be a bold move in the correct direction to safeguard broad economic health albeit been an unpopular action which has sent shockwaves amongst the masses. Further the increase in interest rates and the floating of the SL Rupee went against the policies and forecasts put forward by the Central Bank during the past few months, hence created a negative sentiment within the business and investing community in Sri Lanka. The sharp upward revision in retail fuel prices would trigger a chain of events which would create inflationary pressure (since all goods and services would increase in price) and curtail GDP growth. Albeit been necessary actions, increase in interest rates, weakening SL Rupee and price hike in fuel has negatively affected the thinking pattern and psychology of Sri Lankans and hence we believe with dwindling disposable incomes, they would be cautious in spending which would lead to slower GDP growth in 2012.

Given the current global and domestic economic scenario we believe the Sri Lanka Rupee would remain volatile for few weeks and settle at c. LKR119/US$. Albeit if panic struck exporters refrain from bringing back foreign currency earnings and if the outflow of foreign currency denominated assets continues (either through banking or grey channels) pressure on the local currency would increase. Inflation could edge up towards double digit figures by 3Q2012 and average lending rates may hit 18% levels by end 2012. Therefore we believe GDP growth in 2012 would peter out to c. 6.6% (revised down from the earlier forecast 7.9%) from 8% last year.