Sri Lanka looks beyond euphoria

Euromoney, November 2009

http://www.euromoney.com/Article/2331913/Sri-Lanka-looks-beyond-euphoria.html

If you think a rebound in world stock markets improves your mood, try the end of a 25-year civil war. Interviews in the Sri Lankan capital of Colombo reveal a sense of unbridled optimism and opportunity.

“It’s a pivotal moment,” says Nick Nicolaou, HSBC’s CEO for Sri Lanka and the Maldives. “When a conflict like this is over – and you can look at analogies like Northern Ireland or Kosovo – the post-conflict scenario is one of great hope and an increase in economic activity and foreign direct investment. That’s the background that everyone is looking towards.”

The country’s major industrialists see the end of the war as one of the most significant developments in their recent history, in a business as well as a social context. “For us, it is going to be a complete change in the way we do business,” says Ajit Gunewardene, deputy chairman of John Keells Holdings, Sri Lanka’s biggest conglomerate and listed company with interests from plantations to food and beverage, transport, leisure, property, financial services and BPO. “The way we have done business for the last 25 or 30 years is no longer relevant.”

A few years ago, John Keells had become so big it had outgrown the country, partly because of the constraints imposed by the war, and so had begun a regional strategy. “We have now put all that on the back burner. We are focusing on the opportunities in Sri Lanka, and we believe those opportunities are going to give us better returns than what is available elsewhere. We expect the economy to grow at a minimum of 8% a year for the next few years: it’s not a complicated decision for us to decide where we should be.”

And it couldn’t have come at a better time – for as little as nine months ago, Sri Lanka was in a perilous situation. In recent years despite the war Sri Lanka has managed to keep its head above water and record annual GDP growth rates of 4.5 to 6 per cent. But by early 2009, with the global financial crisis and continued expenditure on the war having an increasingly damaging effect on the economy, full-year growth of around 2% looked more likely. Conflict was draining everything: the necessity for a vast armed force, fully equipped, in a nation that had once had only a symbolic force and could spend their money on welfare instead; lost potential from agriculture and tourism, which ordinarily would have been mainstays of the economy in the north and east where the war was taking place; use of the complex irrigation set-ups linking the dry and wet parts of the country, which ought to have benefited the east; the ability to exploit fishing stocks off the north and east coasts. “The war naturally brought a straight burden on the finances of the country,” explains deputy finance minister Sarath Amunugama, who is also the minister of public administration and home affairs (the formal finance minister title is held by the president). “But it also was a burden in terms of the potential we missed in the one third of the country that was inactive.”

And then the country went straight into the teeth of a foreign exchange crisis. Sri Lanka had permitted foreign investors to take up to 10% of government securities, but they almost universally pulled their money out early this year, as they did from most emerging markets during the worst of the crisis. “There was an outflow, not because of anything problematic in our economy as such, but because of what was happening elsewhere,” says Uthum Herat, deputy governor of the Central Bank of Sri Lanka. On top of that, movements in commodity prices had also depleted reserves. By March foreign exchange reserves had plunged to around US$1.2 billion – barely a month’s import cover – with almost all of the foreign holdings in the government securities market withdrawn.

Almost everything that has happened since then economically has been good news. History will probably judge May 18 2009 as the formal end of the war, as that is the day Velupillai Prabhakaran, the leader of the Liberation Tigers of Tamil Eelam (LTTE, or the Tamil Tigers), was killed, but it had been clear for some months that it was nearing a conclusion and it is really this realization that marks the turning point for Sri Lanka on a number of economic levels.

In July, after some months of negotiation and delay, the IMF approved a 20-month US$2.6 billion stand-by arrangement to support economic reform, US$322.2 million of it upfront with the remainder to come in quarterly instalments subject to reviews. “Without doubt, that has put a backstop on the foreign exchange reserves, and with that has come more investor confidence,” says Nicolaou. The same month, the sovereign took off around the world on a non-deal roadshow organised by HSBC and JP Morgan, and within weeks it had a clear illustration of how sentiment had shifted: a US$875 million investment in four- and six-year treasury bonds by a single US fund manager, believed to be a hedge fund. Total reserves now stand at US$4 billion, and the coffers will be further improved by a US$500 million global bond issue (see Euromoney, October 2009) which is in large part about putting a flag in the ground and setting a benchmark for pricing for the new, peaceful Sri Lanka.

So, with the fiscal position redeemed, what now? Where to start? Because, though the mood of optimism is tangible in Sri Lanka, there is much to do and none of it easy. Most obviously, there is a pressing need for basic infrastructure development, particularly in the country’s north. Donor funding will accommodate much of it, but obviously not the whole lot – and the government is committed under the IMF program to reducing expenditure, not increasing it. That means attracting FDI, which could require some level of reform in regulation and possibly tax, and in the meantime non-performing loans are creeping up worryingly – today 9% – in the banking system. Human rights groups have raised concerns both about the circumstances of the war’s conclusion and the displacement of hundreds of thousands of people into camps, which may have an impact on the willingness of multilaterals or donors to engage. And there are presidential and parliamentary elections to come early next year, although the president’s popularity is extremely high post-war. “On the one hand you have the euphoria: the huge possibility this country offers for transformational change in the next 10 years,” says Clive Haswell, CEO of Standard Chartered Bank for Sri Lanka. “On the other hand there’s some significant challenges that in the short term need to be managed, and the politics of the election process in the next six months as well.”

Infrastructure is the natural starting point. “That has lagged behind, because the war as consumed a lot of brainpower as well as investment dollars,” says Haswell. “There’s been a steady flow of soft loans and investments by a number of donor countries through this period but it’s still pretty slow in terms of building up the infrastructure of this country, and that’s going to be the main change in the short term.”

Herat at the central bank accepts that the costs of reconstruction will be immense, but makes two points. “Firstly we envisage much of the reconstruction will be funded by donor funds, or by funds at very concessional rates from multilaterals or on a bilateral basis,” he says. “To that extent the burden will be greatly reduced. But even it if it is a burden, it is something that has to be done. This is an opportunity we have not had in three decades and it must be seized.”

Minister Amunugama notes that the situation in attracting donor assistance is different to the reconstruction effort that accompanied the tsunami in 2004. “There was an outpouring of sympathy then, and donor countries were more than happy to contribute. Now it is not so clear, donors are not so unambiguous. But the humanitarian part of it is there.”

The second issue is the restriction on government spending. The IMF facility comes with several conditions. It seeks to reduce the central government budget deficit from 7% of GDP this year to 5% by 2011, by broadening the tax base, reducing tax exemptions and improving enforcement. At the same time it seeks to protect expenditures on social protection, improve bank supervision and restore the reserve position (which is surely already done). It doesn’t seem to leave a lot left over for roads or power.

Nevertheless, bureaucrats seem happy with the terms of the IMF deal. Herat at the central bank says he is “absolutely comfortable” with the conditions because “none of the conditions deviate in any way from Sri Lanka’s own policies. We have no qualms in agreeing to them.”

Herat says FDI has typically been US$600 to $800 million a year in recent years even during the war, and one can see it in the vast expansion of Colombo harbour, as well as a port and a power plant elsewhere in the country also being backed by foreign funds, particularly the Chinese. “I don’t want to put a number to things, but clearly if we can have $800 million FDI when the war was at its worst, it’s bound to increase.”

That’s going to be an important step. “In the immediate aftermath of the war we’ve seen a growth in appetite for investment in government securities. That’s really positive, but it’s not FDI in terms of building productive capacity on the ground, we’ve yet to see that,” says Haswell. It’s naturally going to take time to convince foreign money that this really is the end of conflict. “There’s a number of questions people will have from a risk point of view before we see a big step up in international appetite,” Haswell says.

That apart, there’s the broader environment for FDI. Amunugama points to widespread investment in areas like telcos – where Telekom Malaysia, India’s Airtel and Singapore Telecommunications (through Airtel) are all heavily involved in Sri Lanka – as evidence that the environment for foreign involvement, particularly through partnership, is attractive. 

But others think more could be done. Sri Lanka ranks 105^th out of 183 in the World Bank’s ease of doing business rankings, and is among the very worst ranked in terms of getting construction permits, registering property, paying taxes, and enforcing contracts. (On this point, each of Standard Chartered, Citibank and Deutsche are in disputes with various Sri Lankan entities about derivative contracts; these disputes are in arbitration and all parties declined to comment.) One institution highlights “the processes around legal recourse, around governance, issues of corruption, the huge taxes that get paid”, although the Board of Investments does offer mechanisms to give foreign investors relief from that.

Foreign banks are cautiously positive but aware of the challenges. “Next year you’ll see people dip their toe in the water but you do need to see evidence of change and the government is making the right noises about that,” says Haswell. At HSBC, Nicolaou says “the building blocks are there” and the board of investments is investor friendly, but highlights tax, which in the banking sector can hit 60% once income tax and VAT are considered.

So those are the challenges: what of the opportunity? HSBC is looking closely at project and export finance as infrastructure development gets rolling; even during the war it has facilitated over US$1 billion in finance in Sri Lanka in this area. “With ECA [export credit agency] cover becoming available we are expecting a flurry of activity in that space,” Nicolaou says.

The John Keells group says it is already seeing a difference, with agricultural production climbing and so prices of crops and seafood coming down. “The north and east was the rice bowl for the country,” says Krishnan Balendra, president of corporate finance and group strategy. “Prior to the conflict it produced 850,000 metric tons of various crops. Last year production was only 150,000 tons. Now there’s no reason we can’t get back to those numbers.”

Ajit Gunewardene says “tourism is obviously the quick win” post-war. Sri Lanka’s capacity is about 700,000 tourists a year, he says, and is likely to hit that very quickly, probably next year: in addition to the traditional markets of western tourists, the emergence of India’s middle class has made that the biggest provider of tourism. “It’s going to require a lot of investment to build new capacity. We should be getting to a target of 2.5 million tourists a year in four or five years time and that’s going to require up to 20,000 rooms.” Already the group is planning ahead, and is looking at three new projects next year: a brand new hotel on the west coast and two upgrades, one of them in east coast Trincomalee, which has been effectively out of bounds to tourists for years. The following year he expects to develop two more, including another in Trincomalee. Elsewhere, he expects property to be a boom area as falling interest rates prompt people to seek mortgages again.

For Rajendra Theagarajah, managing director of Hatton National Bank, one of the country’s leading banks, “we believe the bread and butter is to scale up fisheries and agriculture.” For that to succeed, he says, money is not enough: there needs to be access to markets, and storage facilities. Hatton’s approach has been to set itself up as a linkage between the buying power of its corporate customer base and the newfound sales capability of producers, “to make sure this is a win win for all of us.”

Hatton, like many others, is also looking with interest at the new funding opportunities that may arise from Sri Lanka’s improved visibility on the radar screen of international capital – something the sovereign bond issue will be very important for. “For the likes of us who have been clenching our fists and managing with internally generated funds for the last three to four years, we could look more optimistically at raising a different style of finance for growth,” he says. “A number of us have been showcasing ourselves beyond Sri Lanka. Now it is time to say there is a specific plan: come and back us.”

There is one caveat to the optimism, though. When Euromoney asked interviewees about whether they thought war really was over, almost all spoke about the obliteration of LTTE as a military force and the discovery of arms caches. Very few spoke about the integration of the different segments of Sri Lankan society, particularly Tamils from the north of the country, into everyday life, or redressing the issues that prompted people to fight or sympathise in the first place. That, surely, will be a challenge as important as any of the others this newly optimistic state faces today.

BOX: the stock market

Stock markets are always a useful barometer of a national mood, and the Colombo Stock Exchange is no exception: its All Share Price Index has doubled so far in 2009. On top of that, it’s also attracting IPOs.

The first post-war IPO was Hemas Power, with an almost Rp2 billion raising that was 3.7 times oversubscribed in September; another, Seylan Bank, was in the markets at the time of writing. More will follow. “We have some in our deal pipeline,” says Darshan Perera, chief operating officer of NDB Investment Bank, which led the Hemas Power deal. “The market is booming.” He says price earnings ratios are now around 13 times.

There is certainly room for more activity. “Only 200 companies are listed on the Colombo Stock Exchange out of 30,000 registered companies in the country,” says Krishnan Balendra at John Keells Holdings. “We think many more will list as valuations are becoming more attractive.”