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September thus far has brought a bag of goodies for the Colombo Stock Exchange (CSE) and the Sri Lankan economy by way of positive economic news and managed to boost domestic investor confidence which was otherwise weak during the first half of the year.

Month-to-date the CSE had gained 2.9 percent with the average daily liquidity rising to Rs 1.9 billion from Rs 1.5 billion which is the average daily turnover year-to-date 2014.

The Colombo bourse had clearly re-rated with the broad investment community expecting faster future growth and looks to add stock in a market which is trading on 15.9x trailing 4 quarterly earnings which would have been otherwise deemed expensive in the war years of pre 2009.

Foreign investor bullishness

Foreign investors continue to be bullish on the economy and the CSE, while been net buyers to the tune of Rs 3.5 billion so far in the month of September. And year-to-date 2014, net foreign buying topped Rs 19 billion with all indications suggesting that the overseas portfolio inflows would last.

Further,  the sustaining factors for the market liquidity levels and index gains have been the wakening of local institutional investors, HNWI’s and a selected segment of retail investors.

 Sri Lanka which has been the best performing frontier market not only on the basis of index advancement but as the economy recording the strongest GDP growth is likely to remain at the pole position with strong macro-economic numbers been released. Second quarter results showed that the real economy had grown by 7.8 percent which was indicative of the annual expected real GDP growth of 7.5 percent to be comfortably achieved by the end of 2014.

If the government’s recurrent expenditure is kept on check during the last quarter of the year, the fiscal deficit also could be contained at around 5.3 percent of GDP. (though seems to be high on absolute terms fiscal discipline seems to be improving year by year with the deficit stemming down from 9.9 percent of GDP in 2009). Thus far in 2014, the trade deficit had contracted by 11.5 percent year-on-year, worker remittances which are almost 8.5 percent of GDP has grown by 11.2 percent year-on-year, tourist arrivals have increased by 23.1percent year-on-year and has resulted with a 33.9 percent year-on-year increase in tourism income.

Inflation kept in check

On the back drop of these developments, inflation also has been kept in check and remains at mid-single digit levels, though pushing it further down to around 3.5 percent in a sustainable manner would be an uphill task despite been the desirable outcome. However for an economy which was used to inflation at high teens, the current inflationary statistics is too good to be true. Also with the government raising debt at relatively cheap rates (given the abundance of liquidity in the global markets), corporates raising both equity and debt capital from the capital markets and foreign funding agencies alongside overseas private equity money flows meeting a large extent of capital needs has eased any pressure on the domestic interest rates. And the build-up of banking sector liquidity in excess of demand for credit would enable a sustainable low interest rate environment.

The local currency which lost 2.23 percent vs the US$ in 2013, has gained by 0.43 percent year-to-date 2014 while the increasing forex incomes, foreign direct investments and portfolio money inflows has created some upward pressure on the Rupee.

 However with the USA expected to lift interest rates in the near future would easily create some portfolio money outflows specially from the bond markets and together with growth in imports could pose upward pressure on the US Dollar. Therefore the appreciation of the local Rupee could reverse with the possibility of losing around 3-4 percent.

However increasing direct foreign funding for various projects and a sharp growth in tourism income could somewhat hold back the Rupee depreciation, though having twin account deficits it would be difficult to shy away from gradual local currency weakness. Appreciation of the foreign currencies would also add fuel to consumer inflation with a 2-3 percent percentage point rise in the inflation index been a possibility. Though in overall context inflation at around 6 percent is not damaging, the concern would be that the urban consumer would be faced with a much higher consumer price pressure which would continue to erode their disposable incomes and again limit demand on banking sector credit and investment. Recently the International Monetary Fund (IMF) had raised concern on percentage deterioration of tax income against the GDP, and mentioned it would be a serious concern if not reversed in order to meet the fiscal deficit targets.

However I believe we need to focus beyond the statement made by the IMF and act prudently. In my opinion trying to widen the tax net, attempt to collect more taxes from the existing tax payers and introduce more taxes on ordinary consumer items, introduce more import levies on the basis of protectionism etc. would create more damage than good.

The reason for lower revenue collection in the form of tax collection is predominantly due to the fact of the private and retail sector been crowded out by the state sector in all economic activities. Therefore when bulk of the economic activities are driven by the state sector with limited private participation, the GDP could grow in real terms but private sector contribution to that growth would be limited and as a result tax payments by the private sector would dwindle as percentage of the GDP.

Tax effect

Therefore my thinking is skewed towards a regulative policy framework which reduces the current tax burden on both the consumers and existing private sector to increase their participation levels in the overall economy which would invariably be beneficial to the country and improve its competitiveness. A reduction in tax rates would revive activity and the volume growth would compensate any loss of tax revenues due to rate reductions while high probability exists for overall combined tax collection to be marginally higher in the short term and gather speed as private sector economic activity bolsters. Then to meet the fiscal deficit targets the most prudent mechanism would be to cut back on recurrent government spending. Such action may not see light given the country would be facing national elections within few months. Otherwise if recurrent government expenditure is to be cut back against the odds it would not only bring down the fiscal deficit (and thereby bring about the benefits of increasing fiscal health) but also serve as a catalyst to attract foreign investments having direct trickle down benefits to the local economy.

Impact on country image

Recent state visits by the leaders of the world’s second and third largest economies have managed to uplift the image of Sri Lanka and has attracted much attention from the international community. Japan which was one time the largest foreign investor in Sri Lanka is now playing catch-up, but nevertheless is a significant positive to the local economy which was otherwise relying solely on Chinese funding (on commercial terms) to develop infrastructure. The Chinese leader’s visit to Sri Lanka is of paramount importance for many reasons.

China clearly mentioned its interest in Sri Lanka is on a long term commercial basis while the island nation is the most vital link in the Chinese maritime silk-road strategy. This level of interest displayed by the Chinese clearly provides political stability for Sri Lanka in terms of regional politics in South Asia and if balanced properly would provide us with the much needed economic super-power backing which we were yearning for since the late 70’s. Chinese funding maybe at commercial terms and could be argued by critiques to be more costlier than alternates while accountability also takes a more relaxed approach. However given the current status-quo avenues for Sri Lanka to gain access for much needed capital for infrastructure development was limited with the exception of the Chinese who are also looking to gain economic control in global resources and trade routes. Then the “Colombo Port City” to be fully built by the Chinese within 8 years at an initial cost of US Dollars 1.4 billion would change the capital city landscape and bring about many indirect economic benefits, while the direct benefit been that Sri Lanka would gain 125 hectares of reclaimed land theoretically for free.

 Port City & CSE

Indirect benefits of the “Colombo Port City” has already begun. The CSE has been a beneficiary with much foreign portfolio money and local HNWI money making inroads to the listed securities. The scale of this project and the fact that the Chinese would be funding it fully has given credibility to the timeline of the project. To give a basic comparison as per the scale of the project, the John Keells mixed development project “Waterfront” is to be built on 10.1 acres of land, the property allocated for Shangri-La Colombo is again 10 acres while the Port City would be a reclaimed land block of 576 acres. And based on the plans, once completed the new city could challenge the established economic centers such as Dubai and Singapore. This alone would be sufficient to re-rate the CSE and the market now trading on mid-teens (trailing 4 quarterly earnings) is not in any way expensive but attractive.

Despite the fact that 46 percent of the completed port city would be held by the Chinese and it’s most likely to house the offices of Chinese companies with commercial interest in South Asia, 125 hectares would be available to the government of Sri Lanka to do whatever as they please. And even if it is leased out to Chinese corporations, there would be no doubt that the new port city would up Colombo’s image and make it a tourist attraction, bringing about impetus to boost the overall tourism growth strategy.

In 5-8 years the city would take a different form, there would be beefed up demand for property, consumer demand within the city could easily increase by two folds and employment opportunities for locals could increase especially from the projects carried out by the local companies. And contrary to popular thought even if a fraction of construction work at the port city is sub-contracted to local companies this would create significant boost to job creation, consumption and corporate profitability. Therefore all this bodes well with Colombo city, alongside its current beatification and development soon becoming an attractive regional hub for South Asian companies bringing it evermore closer to the economic and shopping hub status.  

 FTAs with China

The next catalyst for growth would be the finalization and implementation of the free-trade agreement with China. However it is most likely that negotiations on such pieces of legislature with economic significance would be more tilted towards the larger economic power.

Nevertheless if Sri Lanka manages to safeguard its natural resources and employment for the local population, the benefits from such an agreement could outstrip the negatives given the locational advantage and the ability of leveraging such a free trade agreement to open up entire South Asian markets to Chinese products and services.  

 Therefore if tax reforms with the focus of boosting consumption and reducing the share of wages spent on essentials are implemented the incremental growth of the CSE and interest on listed counters would witness a marked surge.

And the national election jitters also are unlikely to unsettle the capital markets since both the ruling government and the main opposition are pro-business and supporters of investment. Therefore if elections take place early 2015, the victor whichever party it maybe, if prudent would be focusing on private sector growth, ensure economic benefits trickle down to the masses and increase consumer consumption. The capital markets would not budge even if inflation numbers increases marginally as long as consumption and credit growth expands. Interest rates, at around the current levels would be a significant facilitator for equities growth and the medium term trajectory for the CSE would most likely be upwards though few bouts of profit taking could create some index volatility.