Lion leads frontier markets

Industry experts urge disillusioned local investors to ‘buy when it’s down and sell when it’s up’

By Cassandra Mascarenhas

In a highly volatile atmosphere and with low investor confidence in the Colombo Bourse, experts earlier this week went against the negative sentiments and instead stated that now is the time to buy. These views were aired at a forum titled ‘Sri Lanka Economy and Strategy’ hosted by Acuity Stockbrokers earlier this week and featured two presentations and an interactive discussion with a diverse panel of industry experts.

IMF Resident Representative for Sri Lanka and the Maldives Dr. Koshi Mathai (right) speaks at the panel discussion  whilst others from left are Frontier Research Director Amal Sanderatne, Expolanka Holdings Group CEO Hanif Yusoof, Daily FT Editor Nisthar Cassim (Moderator) and  Hatton National Bank MD and CEO Rajendra Theagarajah – Pix by Daminda Harsha Perera

“It’s a bearish market and I’m bullish in it”

The forum commenced with a presentation delivered by Frontier Research Director Amal Sanderatne, who gave a historic view of the Colombo Stock Exchange and shared insights into frontier and emerging markets.

“Markets are quite simple, equity markets in particular. Buy when it’s down, sell when it’s up but it’s easy to forget that. The most useful way to get your grounding is to understand the psychology of the market. Two years ago everyone was investing in the market – huge thrill and euphoria in the market,” he stated.

“Today we are at despondency, disgust, fear – which has passed – now people are just tired of it. You need to keep an eye on where you are and have a clear impression of where the market cycle is right now.”

He noted that the same emotions were very prevalent in the years 1998 to 2000 during which it was very negative and reminded the audience where Sri Lanka has gone since then. Looking at in terms of market cap, the country was at just Rs. 80 billion and it is 23 times that today. There used to be celebrations at turnover levels of Rs. 10 million and we have gone a long way since then.

At that time, the concept of frontier markets wasn’t the big theme. The big index providers never had frontier markets indices. In 2000, Sri Lanka was classified with the emerging markets with Zimbabwe and Slovakia but in terms of market cap and other factors, the country fell with other frontier markets.  

What is the case we can make?

Valuations were cheap but an argument was the diversification benefits of Sri Lanka. Sri Lanka at the time had a minus beta – if global markets went up, Sri Lanka went down and vice versa – the country was not linked to global market and if someone wanted to diversify their risk, Sri Lanka was an interesting market.

Today, Sri Lanka is on the frontier markets index with a respectable 2.4 per cent listing and these markets over the years have tended to outperform other markets.

“Apart from the frontier markets, our view on Sri Lanka and our continued optimism was based far more on arguments about probabilities than ones about certainty. We said that if peace prevailed in Sri Lanka, the market would immediately double which is how we tried to keep people in the market. Then we had the ceasefire bull run. A potential game changer, just like the end of the war turns things around,” Sanderatne observed.  

Now, around mid 2013, there are indications of oil in Sri Lanka but don’t know if it is commercially viable but if it is, it will be a big one, he enthused. Oil can impact the economy in the long run. Markets don’t necessary look at the long term but investors love big news like this.

“What would happen if we announce this? Money would start flowing in. I place a 40 per cent probability that oil will be found in Sri Lanka. In terms of returns that will come up to a 20 per cent underlying option on oil in the market right now,” Sanderatne approximated.

“Don’t bet against oil – the unexpected can always happen and make markets move. There is an implied option on oil right now. Market sentiment is so depressed, it’s a great time to get into the market and you have the traditional arguments as well.”

How Sri Lanka is stronger than its peers

Up next was Acuity Stockbrokers Assistant Manager – Research Chethana Ellepola who delivered a presentation based on Sri Lanka’s ratings on several global indices.

Sri Lanka is classified as a frontier market which is in turn defined as being an ‘emerging emerging’ market and such markets are known for their inherent risk factors.

“Obviously we are not saying Sri Lanka is devoid of these issues – low liquidity and currency volatility affects Sri Lanka but compared to its peers, the country’s broad institutional framework is stronger than that of its peers,” she stated. She added that when talking about institutional frameworks, she was referring to the broad aspects and not specifics.

Looking at a number of surveys, it is obvious that Sri Lanka’s ranking in each survey has improved vastly since its position in 2008.

In the World Bank Doing Business Index, in 2008 Sri Lanka ranked 101 out of 183 but now it is 89 out of 183. The country’s improved ranking is primarily because of reforms in paying taxes and protecting investors. “We need to look at changes over time to really analyse the country. While Sri Lanka is quite a distance from the benchmark in certain aspects, the country is closer to the benchmark in others and has made improvements since 2005,” she noted. Furthermore, the ranking is much higher than its frontier market peers and the South Asian average of 117.

Looking at the World Economic Forum Global Competitiveness survey, Sri Lanka’s peers falls into the first stage of being a factor driven economy. Overall Sri Lanka’s ranking on this index is high – 52 out of 142 countries. Moreover in areas that are considered difficult for doing business, the country has been making improvements since 2008.

These areas include Government instabilities and inflation, however in other areas like taxation and policy instability, Sri Lanka needs to improve and doing business is considered problematic due to these factors.

The KPMG Change Readiness Index is considered an alternative to traditional performance indexes and the index categorises the ability to change in economic capability, governance capability and social capability.

Sri Lanka ranks above its peers at 22 out of 60 countries both in the overall index and across the three broad spheres indicating that adaptability and capability for change is strong.

Sri Lanka’s broad institutional framework is much stronger than those of its peers and the diversification benefits that they provide are a draw factor. The country’s correlation to S&P index is 0.12-0.23 which is much lower than other regions. The positive yet very low correlation over the past 12 years is another draw factor for Sri Lanka.

On a monthly basis, Sri Lanka has a correlation with US equities which is much lower than its peers as well as on a quarterly basis. It’s not only to US equities that Sri Lanka has a low correlation but also with other advanced markets like Europe, Germany, Japan and the UK.

“Why should we be looking at frontier markets in the first place? The answer to this is the current global economic environment – the diversification that Sri Lanka and other frontier markets can provide will be important going forward. The world GDP has been propped up by developing economies,” Ellepola said.

“Sri Lanka makes a convincing case. Valuations are becoming increasingly attractive and the current P/E ratio of 10.69 is becoming more comparable to emerging market economies. Foreign investors are beginning to notice this trend,” she commented. “If you look at the year to year foreign inflows into the market, you see an increase in net inflows into the markets – an increase of over 200 per cent. It is evident that foreign investors are beginning to recognise Sri Lanka’s potential and perhaps it’s time that we too took into consideration Sri Lanka’s investment potential.”

Sri Lankan Lions, Asian Tigers and European Bears

The keynote address was delivered by the IMF Resident Representative for Sri Lanka and the Maldives Dr. Koshi Mathai, who commenced by giving a macro viewpoint of the world economy to date.

“We have seen a few anaemic years. The world economy was close to four per cent growth in 2011, a slowdown this year as expected and then the slight pick up next year. Masking this relatively benign headline figure for the world, we see a great deal of variation,” he commented.

Advanced economies in Western Europe are basically not growing very fast at all, at one and a half two per cent growth, and it is the emerging economies that are really driving world growth ahead. The US economy is growing at a modest rate. With the emerging economies, Asia is leading the pack with China and India in the front.

“Now what has happened recently is that we have had some surprises in terms of first quarter growth. First quarter growth across the world ended up being a little stronger than we expected but mostly, the growth momentum has weakened and risks are rising amid renewed financial stress. Things have gone up and down, more down than up and we certainly don’t find ourselves in a settled situation,” Mathai said.

Looking at how financial markets are doing, measures taken imply volatility in the stock market growth in the US and in Europe. This started in 2010 and there have been peaks and troughs, correlating with the news about Greece, Ireland and Portugal over the last few years.

 “It’s quite troubling really because we see ourselves in a continued cycle of difficulties, then some consolidation in terms of policy response, some relief in markets and then once again a renewal of difficulties and we find ourselves in a never-ending cycle.”

“The sovereign debt is in the centre of the latest phase in the world economy. Looking at credit default swap spreads for government bonds. In April 2010, Germany, France, Spain and other large economies accounted for most of the sovereign debt in the European area. Now two years later, only Germany with a couple of other countries looks okay.”

There has been sovereign deleveraging. The first idea is that governments need to tighten their fiscal policies and they have already have been tightening their fiscal policies and that naturally serves as some kind of brakes on growth. Portugal, simply because of the fiscal tightening that they have done is going to drag growth down by a whole six points.

In terms of bank leveraging and there are interbank relationships that need to be taken into account. Banks in Europe have taken a hit which have in turn affected banks in emerging Europe. Latin America is less exposed as is Asia as banks in most Asian countries do not have direct funding lines from European banks.

Looking at general capital flows shows that over the last two years, flows into emerging funds were positive amounts in 2010 with a sudden drop at the beginning of 2011 and then suddenly flows in and flows out again which makes sense over a 30 year period but over a two year period, this sort of movement has an impact on emerging markets.

In terms of exports, the impact is higher on emerging Asia with its high number of exports to the Euro zone and the US. Overall there is a moderate forecast of growth but the focus is still very much on the Euro area.

“Sri Lanka has grown fast in comparison to its own history and has grown fast in comparison to other emerging and frontier markers. Even looking at growth of somewhere below seven per cent this year puts the country in the top third. In terms of inflation, it’s not a great achievement as other countries have managed lower levels of inflation, especially seeing that inflation has risen again,” he noted.

Looking at fiscal aspects, the Government’s spending has been a major weakness of the Sri Lankan economy for years. When taking the overall balance in the Sri Lankan economy deficit into account, the fiscal balance has been showing a deficit since 2005 expanding to about 10 per cent in 2009 and after that a steady improvement is seen, to eight per cent, heading to six per cent this year.

With the tightening of the fiscal deficit, there has been an improvement in the debt to GDP ratio which has been coming down steadily from very high levels but coming down nonetheless.

He made two points here. One point was that the Government had to be given credit for tightening its fiscal policies. The other point was that it was not all coming through their efforts. A good part of it is coming through the automatic debt dynamics in this country. The fact is that Sri Lanka is blessed with a relatively low interest rate on external debt. The growth rate of the economy is going at seven to eight per cent.

“If you have a debt to GDP ratio during this growing economy at 1.5 per cent when the denominator is growing from six to eight per cent, naturally the deficit will come down over time as long as you are not dumping a huge new financing deal down the system every year in terms of the primary deficit. So what the Sri Lankan Government has done is avoid that big deficit every year and let financial dynamics take their natural course,” Mathai explained.

An important point he made was that while debt is going in the right direction, in comparison to its peers, Sri Lanka has got a very high debt ratio and a very big deficit whereas some of the other countries have a surplus like Chile and Russia with their very low debt ratios.

“I would like to make a small point about the CPC and CEB. The international oil price is quite high and there hasn’t been a full pass through of the fuel price increases to the domestic consumer and of course there are social reasons for that but the end point was that it has resulted in massive losses. Now these losses come from a number of causes – there are inefficiencies in these enterprises, very expensive generation costs which is probably the main reason.”

Bank and credit growth

Private sector credit growth dipped sharply in 2009 and there was even a period when banks were withdrawing credit from month to month. Starting in 2010, banks started lending like mad and there was a dramatic rise in credit growth and it stayed there for many months.

The problem was that the credit was growing to fuel imports. When credit is extended it goes towards imports and imports into the country are increasing. Overall imports grew a great deal in 2010 and 2011. There was a more than 50 per cent increase in the country’s import bill. A very little bit of it was coming from consumer goods.

Because of that import growth, even though exports in the country were continuing to grow, there was a very clear widening in the deficit and even though remittances and service credits were doing well, because of the trade deficit widening, there was a widening of the overall current account deficit.

“At some point policy makers needed to realise that it was a game they couldn’t play forever and the Central Bank and the Government did realise this and brought about exchange rate flexibility, with more movement in rate and less intervention, monetary tightening through policy hikes and a credit ceiling, and fiscal tightening through the energy price hike and vehicle duty increases and generally a commitment to policy flexibility,” he observed.

“To their credit, they have stepped away from dollar intervention in the market. These changes should help address imbalances and deliver sustainable growth. Growth will be slow and inflation will rise but they are necessary – the balance of payments should turn around and reserves should be safeguarded. This will imply more sustainable growth.”

Panel discussion

The panel discussion, along with Sanderatne and Mathai, featured Expolanka Holdings Group CEO Hanif Yusoof and Hatton National Bank MD and CEO Rajendra Theagarajah and was moderated by Daily FT Editor Nisthar Cassim.

Q: Would you like to give a brief banker’s perspective on matters?

Theagarajah: What we have seen in the past 24 to 30 months was literally a reverse in policy rates which were in the mid-50s in mid-2009. The concern is the volatility and uncertainty. We certainly saw a shift towards asset allocation outside the deposit product in 2010 and 2011 but now as interest rates are in rising, there tends to be a shift into deposits.

From a medium to long term perspective, certainly the market should encourage investors and continue to encourage allocation towards non-deposit based investments so that it will help the long term domestic market.

Q: What is your advice for investors getting back into the market?

Sanderatne: My view is quite clear. Obviously how much you allocate equity depends on your individual risk return tolerances, your investment horizons and so on. When things are despondent, you get into the market and when things are euphoric, you get out of the market and now is the time to start putting money into the market and if you can take the risk in a big way.

Q: There are encouraging signs but still there is an idea that the current value is not the real value. Can you comment on this?

Mathai: I think you’re asking me to make a call on the rupee! In general terms, there certainly were pressures, they took these steps and now it’s a matter of waiting for them to take effect. There was a very similar situation in Vietnam, they had very similar pressures on the external side and they took similar measures and it took some months for the effects to be seen.

Certainly in terms of external balance, you will see exporters responding and you will see a more immediate response in terms of imports. Here in Sri Lanka, we have seen some response on imports already. The credit growth still seems relatively high although it has experienced a slowdown and has come down from the peak of 35 per cent.

One can explain that by saying that if banks have a certain credit ceiling that they are allowed to go up to by the end of the year, they would possibly want to push as many of those loans in order to earn interest on them during the year and not just slowly move up to that level. That could be one thing that is happening and I hope so but certainly that is one area that bears watching.

Certain fiscal data also bears watching. You can’t take the fiscal data from the first four months of the year and just multiply it by three. Just because there has been a large deficit in the first four months does not mean you will get that times three for the whole year. We had great targets for end June and they met those targets.

The Government continues to say that they are committed to meeting the 6.2 per cent target set for the deficit but no doubt there will be pressure on them. The economy has slowed, imports are coming down and revenue will come down so there is no doubt that there will be some pressure but the Government seems confident.

The key is that the authorities are being very flexible about their policies so if the rupee needs to depreciate more, they will let it do so. If it doesn’t, it will go in the other direction. I think that in an economy where there are capital flows, it is very difficult to make predictions about where exactly the currency is going to move. We have economic models but when you have capital flows in and out of the country it is very difficult to make such a call.

Q: Do you think the rupee will stabilise below the Rs. 130 levels and are you with the Government in terms of achieving the 6.2 per cent deficit – yes or no?

Mathai: It is very difficult to make such a call. In terms of the Government’s fiscal position, it really is up to the Government itself. The improvement to the debt ratio is simply because there has been this automatic debt dynamic and the interest rates have been relatively low and there hasn’t been a huge reduction in the deficit. In Turkey, they were running 6.5 per cent primary surpluses year after year after year.

In order to bring the debt ratio down and they had to do it because their interest rates were very high and there was no other way to bring the debt ratio down. They had a more modest fiscal adjustment. The flip side of that is that they have done that in a relatively high quality way. They did it by freezing the capital budget for about five years. After they got that ratio down to around the 50 per cent rate, we started talking to them about improving the quality of this fiscal adjustment.

Here in Sri Lanka, we have had a relatively high quality fiscal adjustment in the sense that the capital budget has never felt the axe as it usually does in most countries. Now if push comes to shove, there is some room for compressing that capital budget.

Q: Given the challenging fiscal and monetary outlook, do you think investors should think differently or just start disregarding economic growth forecasts?

Sanderatne: It is a very surprising thing. All the research that have been done on markets, and this is more in terms of long term performance, is that the correlation is negative – high GDP growth in low performing markets. It’s something to do with the fact that when GDP growth is very strong, you get a lot of competitors coming in but in a pessimistic scenario, less people want to compete so you are more isolated so the returns on capital tend to be higher.

It’s a very intuitive thing. From a market’s perspective, in academic research, you clearly find this reverse correlation. Not that I suggest that you need to invest in the market because the outlook is bad but yes, I think you disregard the GDP in terms of growth performance. Look at the valuations; they reflect the amount of pessimism you see in the market so it gives you an idea if the returns are there and people will make money even if it is a bad situation. Great businesses have been created in adverse situations.

Q: What is the real outlook?

Yusoof: I’m a businessman. I’ve seen bank interest going up before. They are tough days; we have to come up during the adverse times. We were surprised when the interest rates came down and they are going up again but we have seen this happen before. I remain bullish.

Q: You are an industry specialist. With Sri Lanka positioning itself as a maritime hub, what is the scope for industry specialists in freight forwarding and shipping in terms of real potential to raise capital?

Yusoof: From the shipping and freight side of it, as one of the first companies to venture into frontier markets, of all the countries that were mentioned before, I can tell you very clearly that doing business here was much easier than all those countries for many reasons – telecommunications, banking and so on. We thought it would be a cakewalk in countries like Vietnam, Bangladesh and Africa but that wasn’t the case.

Coming back to the hub concept, it’s a great opportunity that has come to us. This is the best time that will ever come in our history. We have always been a transhipment hub, always been a place where ships dock. For me, this whole concept of becoming a maritime hub is very timely. These are challenging times. We are surrounded by two great hubs – Dubai and Singapore. South Asia has its challenges but having a hub here is right. Our port is getting extended and if you build a port and don’t get ships, you divert ships.

Q: A lot of banks are exposed to the market. Provisions are made in the first quarter. Is there a concern to the banking sector?

Theagarajah: Maybe in general but certainly with the bank that I represent, we are prudent in what we do and we take the provisioning head on. What you see is what you get so I don’t think that is an issue. From the 2000 story, a lot of us don’t realise where we started out 10 years ago and where we are today and the concept of pricing and the correct value for people to enter.

For emerging market and frontier market investors, if the price is right and the policy framework is sound, they will come in and they will come in knowing that it is a frontier market and expecting returns.

There had to be corrections and they aren’t helping those who are holding on but they are sufficiently attractive for those are looking for opportunity. Unfortunately now we are in a catch 22; there are people looking for opportunities on the other hand, there is no liquidity and I think that is a very important thing. Certainly at HNB, we on average get two to three frontier market funds coming in.

Q: What is that locals don’t see that foreigners see in Sri Lanka? We have a Rs. 24 billion net inflow, of course that is on select blue chips, but still foreigners are buying and in relative terms it’s fairly high. What is the difference?

Sanderatne: I think again it simply comes down to the value question. If the market was expensive, they saw it as expensive. They probably tend to follow better processes. They understand what relative valuations are historically relative to other countries. There are certain banks that are below book – let’s buy those banks. It’s very simple, sell high and buy cheap. Why locals don’t see it is because they are very involved in the whole situation.

One of the problems here is you end up talking to the same groups that have lost money – investor psychology is very important and that affects your psychology and you will not see the fact that things are cheap because you are getting affected by the fact that everyone else is seeing things very negatively and that is why you need to think differently.

Q: Can you talk about policy flexibility versus consistency?

Sanderatne: What Koshi spoke about was flexibility in terms of exchange rates and what Rajendra spoke about was about consistency in terms of policy frameworks and such. When you are in the market, you have to accept that monetary exchange rates move.

Mathai: There is no problem if rates move, but I agree that there needs to be a stable framework.

Q: We don’t see much interest in the market from institutional investors – why is that?

Sanderatne: We got seduced with this idea of double digit growth. It’s good to look at the facts. Singapore and China are the only two countries who have grown at nine per cent consistently. The places we aspire to be like are Thailand and Malaysia, which are countries that have grown at six to seven per cent on average. The key is consistency. If you run at six to seven per cent with consistency, you get to where you want to go. Six to seven per cent is good enough. Institutional investors in our marketers are responding to the same psychological factors.