LONG-TERM OPPORTUNITIES AMIDST POLITICAL UNCERTAINTY
SRI LANKAN BUSINESSES HAVE OPPORTUNITIES TO INVEST FOR LONG-TERM GROWTH DESPITE POLITICAL UNCERTAINTY HOLDING THE ECONOMY IN ITS GRIP AND FALLING CONSUMPTION. THE OPPORTUNITIES ARISE FROM SEVERAL REFORMS UNDERTAKEN BY THE SHAKY COALITION THAT WILL PLACE SRI LANKA ON THE TRAJECTORY TOWARDS FAST GROWTH.
However, an election cycle in 2019 risks putting the reforms agenda on the back burner. Whoever takes government in 2020 will have to put back reforms high on the agenda, fast, for Sri Lanka to achieve high growth by attracting talent, investments and increasing trade in a polarised world. Identifying signs early can help businesses invest in opportunities the reforms will open up, or prepare for the worst.
Discussing these challenges and opportunities are Shiran Fernando, Chief Economist at the Ceylon Chamber of Commerce, Dinike Jayamaha, Chief Executive and Co-founder of Ethical Extracts and Executive Director at Victoria Group, a family business which makes leaf springs, and Purasisi Jinadasa, Head of New Initiatives at David Pieris Motor Company.
Excerpts from the interview are as follows:
Where’s the smart money right now on the Presidential and Parliamentary elections?
Fernando: We have a year and a half till the next elections, so a lot can change in terms of policy direction and sentiment. But smart money has got a lot wrong over the last few years here and elsewhere. No one expected Brexit, Trump or Mahathir Mohamad. In Sri Lanka, no one expected the outcome of the local government elections. Anything can happen. The next elections may be a two-way battle but consensus is not reality, so this is something businesses need to get used to.
Jinadasa: A lot depends on Sri Lanka’s rural community. No one starves in Sri Lanka but for many people life is an uphill battle. That limits their ability to think long term. They think only of their immediate needs. This is something the government needs to address. Infrastructure development will create connectivity and if we can strengthen the good foundations we have in healthcare and in education, then that will complement economic growth as well. We need to be able to do all these things to get growth on the right track. We also tend to focus on the wrong metrics. For instance, while tourist arrival numbers are important, what we need to focus on is average daily spending and how businesses can increase that. Right now, two million tourists spend $150 a day over 10 nights for $3 billion in total inflows. If we can increase the daily spend to $500, it will result in tourism earnings of $10 billion for the same number of arrivals.
You have three possible outcomes. One, the coalition government will continue to muddle along like it did over the last three years, so there will be policy instability and businesses will have to plan around them. Second, the coalition government may realise it needs to get its act together and get something done before the next elections. It may have a list of priorities given the limited time available. The challenge for business is to identify those areas and plan accordingly. The third scenario is where nothing gets done; then businesses may have to buffer themselves until clear opportunities hopefully become clear after elections. It’s important to remember, however, that political stability does not always guarantee economic stability.
Are there long-term investment opportunities available right now?
Jinadasa: I would suggest that businesses need to look around at what the government is doing right now, identify long-term opportunities and position themselves accordingly. For instance, when the Southern expressway came up, land prices appreciated. So businesses need to look for similar opportunities elsewhere. It’s difficult to predict what will happen politically or economically, but businesses can position themselves around the many infrastructure projects that are taking place right now and build cash buffers to invest in, or shift positions as and when the need arises.
Any business, listed or otherwise, with a bandwidth to invest long term should have a buffer to be able to deploy whichever way the wind blows. However, there are great long-term investment opportunities for businesses. Infrastructure development is opening opportunities in the real estate space. Business will be able to create better jobs with better pay and this leads to consumption growth. There is an opportunity to build and grow a business over the next decade in Sri Lanka with accessibility to global markets.
We should focus more on knowledge services. Just services in general, because there is a narrative here that suggests Sri Lanka needs to get into manufacturing. Sri Lanka doesn’t have the capacity or the capability to compete with industries in Bangladesh or India. So forget about manufacturing. IT and financial services are promising sectors to invest in, and Sri Lanka has some really bright people in these areas.
Fernando: There are investment opportunities in the start-up space and next generation businesses that are looking at producing digitally enabled products and services for global consumers. We need companies that will drive the next industrial renaissance much like what MAS and Brandix have done.
Jayamaha: If I were to put all my chips into one sector, it would be services. Looking at the next two years we expect disposable incomes to be low, which means most families have two breadwinners leaving less time for household chores. So there’s opportunity here for companies to provide a range of services that can free up time for families. There’s a large, untapped market in this segment. Affordable housing will be another area with a large middle and low income market. If you can offer any service that saves people’s time and money and if they use your services no matter what, you can’t lose. Those services are where I would put money in.
Q: Any thoughts on the rise of populism?
Jayamaha: Everyone has been waiting for the economy to take-off, but it never happened, not after the war or after the 2015 elections. The one time Sri Lanka did take-off was after the economy was liberalised in the late 1970s. For an economy to really take-off, that is, to grow at double digits, there has to be a strong exogenous shock to the whole system that elevates the economy to a new level. We did not see this shock after the war, nor do I see anything happening right now to suggest one at this moment in time. From a business perspective, there are two things that are required for faster growth and to elevate the economy to the next level, and we need to look for signs of this happening.
The first is liberalising immigration. This is something Sri Lanka needs for faster growth because it fosters innovation, new ideas and new technology. This can only happen if people are allowed to come in with new thinking, new ways of doing things, and bringing new companies. Take the example of Vietnam. They’ve ventured into new export industries whereas Sri Lanka has done nothing beyond garments. Vietnam has leaped to the next level of economic growth with electronics, machinery and technology exports. They did this by attracting the right people. Sri Lanka needs liberal immigration laws so that resourceful and talented people move in with their families and this creates a new ecosystem as well. The Board of Investment is doing a lot in terms of making it easier for companies it approves to hire the required talent from overseas, but this is not open to other businesses.
Second, labour market liberalisation is an area businesses are keenly interested in. There’s access to a relatively low-cost and educated workforce, but it’s highly politicized. Unions affiliated to political parties cause a lot of problems. It makes any entrepreneur think twice before starting a business. Can they exit as quickly as they entered the market, or will they get dragged into labour tribunals? That creates a barrier to new investments.
If the government continues with its fiscal policy and immigration and labour markets are reformed, then we can be confident that the country is on the trajectory for fast growth. Will this happen right now? Unfortunately, we don’t see clear signs of this. Once this starts happening, within five to six years you’ll see great growth. That’s the best-case scenario that I see. As a business, I would look for signs that these reforms are starting to happen.
Given Sri Lanka’s stage of development, it may be difficult to sustain any realistic growth into the future unless it can do these reforms. Do you think they will remain priorities irrespective of who takes the government?
Jayamaha: Exactly. As a business, I wouldn’t be distracted by who wins the elections. I am more concerned about what they will do. We know what needs to be done in terms of reforms, so businesses need to keep an eye and pick out the early signs and react quickly. There are always opportunities even in a downturn. Businesses must be able to be nimble enough to identify and capitalise on them quickly.
Do the conditions suggest that the government has the political will or the political capital to carry out these reforms right now?
Jayamaha: Certainly not. There’ll be an uproar if the government attempts to liberalise the labour market. Even though liberalising immigration is good for the economy, it’s not a pleasant thing to do. There’s a lot of vocal opposition to the trade agreements with India and Singapore. Most countries that liberalised their economies had gone through the same unpleasant experiences we are going through now, but they stuck with it. The best time for reforms is after an election, so we will have to wait and see. If the government can implement these reforms soon after the elections, it will have four-to-five years to results. So it’s unlikely any of these reforms will be undertaken before the elections.
Fernando: As far as immigration and labour market reforms are concerned, I believe this government recognises the need; so did the previous government. But both governments couldn’t implement reforms because of the political risk involved. While people are in an uproar over any agreement with India, even the FTA with Singapore, a country that doesn’t have any political baggage with Sri Lanka, created a lot of negative sentiment. Everything boils down to what the citizens of this country collectively aspire to be. Everyone wants Sri Lanka to become the next Singapore, but few people realise or appreciate the work that needs to be put in. They don’t have the right attitude. Instead of seeing opportunities to learn and upscale skills and share ideas with migrant labour, they only see threats. There’s a mismatch between our aspirations and attitude and this is feeding into the political sphere, which is why governments are reluctant to make hard choices that can be good for the economy.
Much of our population expect overnight gains, so are GDP growth numbers a useful metric to look at?
Fernando: It may be a useful political took to compare different periods, but what matters is the income element because people can relate to that. One of the reasons why the government changed in 2015 was that despite strong GDP growth people didn’t feel their incomes rising. What matters more right now is what’s happening to the rupee and how much people can buy at the Sunday fair.
Jayamaha: An important aspect of disposable incomes is that Sri Lanka has an unfair tax structure. Over 80% of government revenue is from indirect taxes. This is where the rich and poor are paying the same rate of taxes and this is unfair. Less than 20% of revenue is from income taxes which are based on the ability of a person or company to pay. Indirect taxes are not based on a person’s ability to pay, so poor people will find their disposable incomes shrinking much faster over time. The positive thing is that the government realises there is a problem with the tax structure and is trying to correct this imbalance. If they are successful in doing this then we could see a mood-shift among the masses because food will be less expensive. In terms of the value of the rupee, the currency is closing in on where it should be against the US Dollar in terms of the real exchange rate, whereas in the past the exchange rate was mostly controlled. There is some speculation, but the rupee is closing in on the real exchange rate. I don’t expect the economy will take-off or sink if the rupee is allowed to find its market value, but businesses will change. They will go for import substitution. Local manufacturers competing with imports will start to improve. Exporters will more or less remain the same and there will be no major innovations. The balance of payments could come under pressure and we could see the exchange rate readjust itself.
The government is likely to deliver some short-term gains over the next one and a half years as we enter the elections cycle. How will this impact business?
Fernando: This was expected in the lead-up to local government elections early 2018, but it didn’t happen because of the fiscal constraints and the IMF programme. I expect this trend will continue. However, eight to six months before elections the government will have to get certain things done. Fundamentally, some of the economic fundamentals are quite healthy. If you look at Sri Lanka’s reserves, inflation and even the primary fiscal surplus which was the first time in 26 years, things are not all that bad. We’ve gone out and borrowed from international markets before interest rates could tighten in preparation for debt repayments this year and in 2019. Fundamentally, things have significantly improved but sentiments don’t reflect any of this. The government has shown an inability to convey the positive message, including the reforms it has undertaken which would benefit the economy without having to resort to fiscal spending. Businesses will benefit if the government can be consistent with implementing the new Inland Revenue Act.
Jinadasa: One of the challenges of delivering economic gains to the masses is the gap in income tax collections. Income tax to GDP is around 12%, but in rich countries it’s around 30-35%. The government is trying to address this issue, and if it can bridge the gap by expanding the income tax net, it will certainly help the political situation. However, the average person voting at the elections is not likely to identify with this. That’s probably a challenge for anybody running for office. It’s difficult to predict what businesses would do but judging by past experience many likely will focus on the short-term gains. They may forget about the long term. Strategic growth, diversification and sustainability may get put on hold to the detriment of businesses and the country as well. A short-term boost in consumption will likely improve earnings of listed companies. The Colombo Stock Exchange may see a turnaround due to positive sentiment, which is encouraging for investors.
Jayamaha: For local businesses, the economy is sluggish. Local consumption is flat. In Colombo and elsewhere people are feeling the tightness of money. Goods are getting more and more out of reach. However, consumption will recover as Sri Lanka enters an election cycle and the government starts spending. This can be dangerous for the country’s medium-to-long-term prospects. Government spending in an election cycle will see a small boost to consumption and only for a while. Businesses will see an improvement for maybe a month, but then things will get tough. It’s like getting a credit card and maxing out in the first month. GDP will see a short-term rise due to consumption but not because of investments or net exports. Disposable incomes will rise and disappear as fast and business will soon feel the crunch. After a lag, lending institutions like banks will begin to see non-performing loans rising. Credit growth will slow down and the economy will become sluggish again. The balance of payments and rupee could suffer. Without new investments and technology transfers, exports will begin to struggle. Large exporters will begin to off-shore operations, and this is already happening, because we don’t make it easier for migrants to move in with their families. The local business system will get stuck in a lower value stream in the absence of innovation.
I am not suggesting any of this would actually transpire if there is a little bit of spending in the election cycle, it’s only an extreme scenario much like the one where we suggested Sri Lanka could be like Singapore is we got our act together. The government could pull back some of the reforms so that people get immediate gains. For instance, it could artificially strengthen the rupee instead of letting the market decide the exchange rate, but such measures will only make us worse off in the medium to long term. Despite the negative sentiments, I hope the government is not deterred from pushing ahead with some of the reforms it has introduced which have placed the country on a trajectory towards getting its house in order. This would at least give businesses comfort in terms of policy stability so that they can focus on what they do best. Ideally, adventurous things like migration and labour market liberalization together with policy stability would attract foreign investments regardless of the brain drain and limited resources.
But won’t a short-term boost be good for business?
Fernando: Not really, it would only set us back. Businesses may be enticed to make quick gains and achieve something of a turnaround over the next couple of years. They could even focus away from exports to cash in on domestic consumption rising. However, Sri Lanka should be strategizing to build exports. There is still healthy demand for our exports in key markets, despite Trump and rising protectionism, so we need to be focused. When global trade improves we need to be in a position to benefit, not lose out because of inward-looking policies.
Are we looking at elevated external risks from where they are right now?
Fernando: The US Fed is likely to increase interest rates twice this year and thrice in 2019. The EU central bank will end quantitative easing by the end of 2018. So globally, interest rates will begin to tighten. It won’t be a shock because markets have already factored in the ECB and Fed moves. However, investors will be more selective. There’ll be more high-yielding assets in developed countries, so Sri Lanka may find it challenging to attract investors to its capital markets. This is where Sri Lanka’s growth story will begin to matter. The external factor can work both ways for us. If global demand slows down because of the political uncertainties around us, it could lead to declining oil prices and this can help countries like Sri Lanka.
Jinadasa: Sri Lanka needs to be more focused than ever in how we attract foreign investments. There will always be money chasing after higher yields with the US Fed rate hike and ECB monetary policy tightening. However, if Sri Lanka has an attractive growth story and its risks can be minimised with improved policy stability, if we’re more open to migrants and if we improve the Ease of Doing Business indicators, then the country could still attract the foreign investments it needs to elevate the economy to the next level.
Jayamaha: Globally, there always will be challenges, risks and uncertainties from violent clashes to trade disputes that can vary from time and place. We need to focus on trade patterns and how those are changing. If the US pushes ahead with restricting imports we need to look at how that will impact Sri Lanka. One of the good things this government is doing is focusing on establishing and deepening trading ties in Asia, with India, Singapore and China. This will enable us to balance off any risks from protectionism elsewhere. Some argue that free trade agreements don’t really have a tangible effect on economic growth. However, it’s a good way to realign risks as global power dynamics flow and ebb. Sri Lanka’s location may be an advantage, but the biggest advantage is its large neighbours: Pakistan, India and Bangladesh. So it is important to be a spectator to what is happening globally and seeing which avenues open and where we can benefit. Right now, I think, global risks and opportunities are balanced out.
How will global dynamics impact Sri Lanka’s debt servicing?
Fernando: Regardless of what the political climate is, the debt maturities from now to 2022 will be a constant and external dynamics will be a key part of that. It’s important to track global capital market cycles. From 2016 to end March 2017 frontier markets were not in favour after President Trump was sworn in. The tide turned and we experienced foreign inflows into our bond market for most of 2018, but now it’s turned again. On the other hand, if we look at trade, we see China and ASEAN contributing to Asia’s emergence as a dominant trading bloc. India is also expanding its reach. Sri Lanka’s trade growth will depend on our alignment or non-alignment with the region.
Jayamaha: It will be very important to diversify how we raise debt. We shouldn’t be over dependent on China or any other country. China’s Belt and Road Initiative will open new opportunities for the economy, but we must be careful not to expose our debt and infrastructure to China. We can never predict how global dynamics would play, so we should never align ourselves completely to one bloc because things can change fast and impact the entire economy. We need smart diplomacy.