TOO LATE FOR REFORMS?

The 2018 budget was the best in recent memory for its direction and reforms. However, it’s not good enough to make a serious impact, says Frontier Research

After two years of uncertainty and low growth, Sri Lanka’s economy is expected to have a better run in 2018 and beyond, driven by consumer demand, increasing government spending and a pick-up in exports with GSP Plus trade concessions to the EU taking effect, according to Frontier Research.

Around Rs600 billion of the government’s domestic debt is expected to mature during 2018, exerting pressure on interest rates. Inflation which peaked at record highs in 2017 doesn’t show signs of easing either. However, Frontier Research believes these will not ‘shock’ the economy.

On the positive side, FDI will recover after declining over the last two years and fiscal performance is improving. Frontier Research says the 2018 budget is the best in recent memory. However, the budget comes two years too late, it argues. Debt repayment obligations, national elections and eroding political capital will make it difficult for the government to push through its reforms agenda.

Frontier Research’s Founder and Chief Executive Amal Sanderatne, product heads Travis Gomez and Trisha Peries, and Product Lead Thilina Panduwawala took part in a roundtable discussion to explain the underlying trends in the economy, the impact of the budget, and asset allocations for 2018 and beyond.

“There are other reforms on the table, but it requires managing political capital. In 2018 and beyond, the government is beset by political complications.”
Thilina Panduwawala

Excerpts from the discussion are as follows:

How would you describe 2017 and what’s the outlook for 2018?
Trisha Peries: There were several positive trends emerging in 2017 in terms of fiscal and monetary policy, and exchange rate management. The Central Bank governor assures there will be no sugar-highs and that credit growth is controlled. The Central Bank is maintaining flexibility, giving the market space to determine the exchange rate. The positive effect of this is that foreign exchange reserves have grown to over $7 billion during the year from about $5.5 billion at the beginning of 2017. The fiscal performance is improving, with promising revenue and expenditure numbers. According to fiscal data available for the first eight months of 2017, the government seems to be on track with its fiscal consolidation goal.

Heading into 2018, interest rates are expected to ease. In Sri Lanka, we experience up-down cycles in terms of interest rates. Since 2006, Sri Lanka has been through two up-down cycles, and going into 2018, we believe we’re in the downward leg of a third such cycle. So interest rates will ease during the first half of the year, but there will be pressure for rates to rise as domestic debt repayment pressure builds up in the second half. Around Rs600 billion of the government’s domestic debt is expected to mature during the year, most of this in the second half. We expect interest rates to continue to move upwards in 2019 as well as on debt commitments, and because of increasing government handouts ahead of national elections. On the other hand, we expect the exchange rate will continue to be more market determined. We don’t expect any shocks, but could see 3-6% annualised depreciation of the rupee against the US dollar within the next two years. Consumer demand has been sluggish over the last two years due to monetary policy tightening, tax increases and reducing disposable incomes. However, we believe consumer demand will improve in 2018. Business sentiment has been low, and this is reflected in corporate earnings, but we’ll see a pick-up this year. This positive trend will continue into 2019, with the budget expected to give a further boost before the presidential and parliamentary elections. A rise in handouts before the elections will increase consumer spending and contribute to overall growth.

Amal Sanderatne

What about economic growth? What’s your outlook for 2018?
Peries: At Frontier Research, we don’t really treat Gross Domestic Product (GDP) as a useful economic indicator, because it does not represent what businesses do. We believe that companies don’t rely on GDP forecasts when they plan strategies. We rather focus on consumer demand because that’s what businesses want to know: it’s a better indicator than GDP growth. We tell our clients that GDP growth rates can be volatile and fairly inaccurate in terms of capturing the dynamics of the market. Consumer demand is a better indicator. The economy will have a better run in 2018 and beyond, driven mainly by consumer demand, increasing government spending and a pick-up in exports with GSP Plus trade concessions to the EU taking effect. The main driver will be household consumption, which was low in 2017.

So, you don’t have a forecast for economic growth?
Peries: We do, but we rarely share it with our clients because, in our opinion, this is not a very useful indicator. Our clients are more concerned about business growth and where it will come from: the consumer. There can be problems when GDP is estimated, and when base years are revised, growth rates change significantly. For instance, high growth rates recorded for 2013 and 2014 fell sharply to around 3-4% when the base year was revised to 2010.

What’s your view on inflation?
Peries: Over the past year, inflation has peaked to record highs on the new index staying at over 7% levels over the past few months. As is well known now, this was driven very much by poor supply side conditions due to droughts experienced and the floods, which caused food inflation to rise sharply. Going into 2018, this trend doesn’t yet seem to show signs of easing, with droughts expected to persist in the beginning of next year as well. Further adding to possible upside pressure on inflation in 2018 are energy pricing reforms that are due to come in March and September. These elevated levels of inflation are particularly concerning given that the central bank is expected to move into an inflation targeting monetary policy framework next year as recommended by the IMF.

However, despite the acceleration in headline inflation, core inflation – which excludes volatile items like food, energy and transport – has not followed this rising trend, and is therefore somewhat of a positive in this worrying inflation outlook.

Interest rates will ease before rising again. What does this mean for money and equity markets?
Amal Sanderatne: Our view is that interest rates will ease during the first half of 2018 before increasing, slowly at first, and picking up in 2019. However, it will not be a shock and volatility will be less. There will be a positive story on volatility. At the same time, demand conditions are improving with spending related to the budget in 2019 due to elections. For this reason, we’re more bullish on equities right now than we’ve been for the last one and a half years. We also feel that the market will take time to adjust to the falling interest rate cycle. Not all investors can see what we do. There will be more inflows into the equity market from domestic investors during the first half of 2018. The Colombo Stock Exchange is poised for a strong performance. The equity market here is undervalued compared to most emerging markets, which is why foreign investors are already attracted by cheap valuations. Also, improving consumer demand will translate into better earnings for listed companies. Interest rates rising after the second half of 2018 won’t be a shock to the equity market, either. So, our advice right now to investors is to increase equity allocations.

Travis Gomez

So, investors should start increasing equity allocations. Many hold the view that equity should be a long-term investment. Does this hold up in a market like ours?
Sanderatne: Our view on equity is a short-term position. If the stock market performs as we expect and by June 2018 investors have made their money, we will have to make a call on what to do next. The Sri Lankan economy is very cyclical, so fundamentally, asset allocation needs to be dynamic. I know a lot of people believe in this buy-and-hold strategy, but the Sri Lankan dynamic is very different. We believe in timing market cycles and making aggressive calls on asset allocation whenever appropriate. Timing markets requires a high degree of skill, like choosing the right advisors. Given the current economic conditions and interest rates trajectory, we believe the greater opportunity lies in listed equities.

We’re not talking about buying and selling, or holding for the long term, but timing the market cycle. In any case, for a market like Sri Lanka, one to two years can be considered the investment holding period, which we often advice because of short market cycles. For instance, our view for 2016/17 was bullish on fixed income and not equity. Back then, we estimated inflation to average 4-5% over five years, which meant that real returns on fixed income investment would be high. At that time, the equities outlook for 2016/17 was dull compared to fixed income, especially because the IMF demanded a narrower budget deficit. There was an expectation that there would be a greater focus on austerity and taxation, and this was expected to negatively impact corporate profits. We believed this was factored into the equity market in 2016 and would continue into 2017. If our clients took our advice then, they’d now be sitting on substantial capital gains. Some of them have now allocated more into equity based on our current view. There are still those holdings on to long bonds. As interest rates fall this year, they should be looking to cash out.

What are the hot stocks to go for?
Travis Gomez: We don’t look at individual listed stocks but focus on sectors we can recommend allocations to. One sector with upside potential is banking. Given our view of interest rates weakening during the first half of 2018, a key indicator of banks’ performance, net interest margins, will be under pressure.

“From a macroeconomic perspective, the new laws are good, but they’re also too late, so we won’t see significant near-term gains from these.”
Travis Gomez

However, despite the squeeze in margins, we don’t expect to see “a significant decline. Banks can quickly adjust their deposit rates down while keeping lending rates steady, so net interest margins are unlikely to decline sharply. Banks also maintain conservative positions on non-performing loans and their loan books are fairly diversified so risks are spread. Banks will be fairly stable in 2018 and returns will continue to be consistent. Larger banks have been making average return on equity of about 15%, which is quite high compared to most other sectors In terms of valuations, banks are trading at relatively cheap prices. So banks are a good investment to have. It’s the same for non-bank finance companies, their loan books are growing at a similar rate to banks. However, there’s one advantage finance companies have over banks. When interest rates ease, people tend to shift their deposits from banks to finance companies. During the third quarter of 2017, banking sector deposit growth slowed, while finance companies saw a 10% increase. While this shift is a positive for finance companies, there is a worry that their tendency to be overexposed to vehicle leasing and hire purchase compared to banks could lead to some pressures on performance. We’ve already seen their loan impairment provisions increasing over the last few quarters. So, with regard to finance companies, the larger firms are good to look at because their asset bases are growing; it’s the smaller companies that will face some pressure.

Property development and real estate is another interesting sector although there are varying opinions about the condominium sector as to whether or not a bubble is forming. However, if you look at the listed companies in this sector, most of them focus on the commercial property space, which has a lot going for it including policy support for investments in BPO and KPO businesses to set up here. Demand for office space is growing, particularly high-quality spaces that conform to international standards. So there is good potential there. Some of the listed companies within this sector have somehow managed to maintain high occupancy levels too, and rental yields have been steadily improving; so that’s another sector to look at. Finally, given the amount of activity that is going on in the construction sector, listed manufacturing companies supplying to this sector can plug in to this construction boom.

What’s your view on the condominium market? Is there a bubble?
Sanderatne: We don’t have a view on this, not at the moment. We are working on research to help people in real estate asset allocation, but nothing we can reveal right now.

We have mounting debt servicing obligations and FDI has not flown in as expected over the last couple of years. Will this trend continue?
Thilina Panduwawala: Sri Lanka needs policy consistency. If policy keeps changing from government to government and within the same Cabinet, FDI will obviously remain at low levels, hovering around $1-1.5 billion a year. FDI has declined over the last two years, but is inching up now. During the first eight months of the year, FDI was around $700 million and the Hambantota Port deal could bring in an additional $300 million. The bottom line is, for FDI to take off, Sri Lanka needs policy consistency. The government is pushing for liberalisation and economic reforms, but there’s opposition to these from even within the government.Not only are investors getting mixed signals but confidence in the system isn’t improving as much as is needed. Sri Lanka has had issues with bureaucratic red tape, bribery and corruption, which must be dealt with by improving processes and transparency that allow implementing agencies assisting investors to work seamlessly across the different ministries and government agencies. The government announced plans in the 2018 budget to set up a single window to attract FDI, which will be linked with over 30 other government institutions and a one-stop-shop at the Registrar of Companies. These are all very encouraging. Improving the ease of doing business is a good short-term measure to improve FDI. However, consistent policy is what will sustain robust long-term FDI growth, because investors will have confidence about the future. That’s what is needed to increase annual FDI from around $1.5 billion now to the $5 billion that the government aspires to.

You say FDI has improved slightly in 2017; will this trend continue in 2018?
Panduwawala: That will depend not just on policy consistency, but the government’s ability to communicate a coherent, consistent message. For instance, the 2018 budget proposed liberalising the shipping sector, but the minister in charge of the sector claims he was not consulted and is opposing the move and preventing its passage. Things like this will not attract FDI. We’re not arguing for or against liberalisation here, but it helps if the government speaks in one voice. If Sri Lanka is to be taken seriously, then policy decisions must be well thought out, and, announced and defended in one voice.

Trisha Peries

What’s Frontier Research’s view of the 2018 budget?
Panduwawala: The 2018 budget is not bad, but it’s not good enough either. It’s not bad because it’s the best budget in recent memory. The forecasts and expectations are more realistic, especially revenue estimates. We say it’s not good enough because this budget is coming too late. Had the government proposed a budget like this two years ago when public sentiment was also high, it would have been easier to push the reforms agenda and steer the economy closer to where we all want it to be. However, right now, with debt repayment obligations and national elections expected after 2019, the direction and reforms of this budget may be difficult to achieve. The budget also lacks focus.

It has 200 proposals that account for only 10% of the expenditure allocations. The government is also challenged when it comes to implementation because state institutions often don’t have the operational capacity. Political capital is another challenge. Many good proposals are opposed not just by parliamentarians, but bureaucrats and trade unions, too. On top of that several proposals of the previous budgets have also not been implemented, which has created a lot of uncertainty. The 2018 budget has direction, but achieving 6-7% GDP growth rate and FDI targets will not be easy because it’s coming too late; it has little space to maneuver.

Sanderatne: In a simple sense, if a similar level budget was done at the beginning when this government came in, a lot more could have been achieved. Now, we see too many challenges building up in 2018 and beyond. Had this budget come earlier, the government would have got the momentum going and the country’s actual growth trajectory would have been the goal we’re now talking about. We would have had high growth and high FDI. Sri Lanka would have broken away from the up-down cycles. It’s better late than never, but now with all these challenges, progress is difficult. So, this budget is two years too late.

Heading into 2018 we have a new Inland Revenue Act and a Foreign Exchange Act. What can investors expect with these two coming into play?
Gomez: The core message that I think the government has been trying to push forward with these acts is to create an environment of transparency and stability in terms of the policy environment.

The new Inland Revenue Act is an attempt to introduce transparency into taxation and processes. Definitions and guidelines on corporate tax and taxable profits are very clear, which will make investment and business decision making easier. There is also a shift from granting tax concessions to attracting investment. The new act proposes benefits in the form of capital allowances.

“At Frontier Research, we don’t really treat Gross Domestic Product (GDP) as a useful economic indicator, because it does not represent what businesses do.”
Trisha Peries

There is also an attempt to end the practice of giving tax concessions by guessing which sectors in the economy are doing well. The government is trying to move away from that and from the discretion that is given to the finance minister, replaced now by this very clear system. A positive thing about the 2018 budget is that the government did not deviate from this course. They did not try to change the corporate tax structures of the Inland Revenue Act. The tax concessions were limited to a very few things like renewable energy and dairy. It’s evident that the government is intent on achieving consistency in the taxation policy, which is something that foreign investors want rather than particular benefits to set up industry here. That’s really what they want to see if policies are in place, so they have the confidence that things won’t change dramatically. It’s the same with the new Foreign Exchange Act. There’s a shift in attitude: from a mindset of control to management, from constraints to facilitating within the systemic framework. This opens many opportunities for Sri Lankan businesses to venture overseas. The new act has increased limits on how much can be invested and where. For example, listed corporates can invest up to $2 million to access international markets to buy stocks and investment bonds, and this helps diversify risks. The act also broadens the inward investment categories for foreign investors. This is an investor-friendly move. Despite the positives, it all comes down to how effectively the Inland Revenue Act and the Foreign Exchange Act are implemented, whether or not they generate growth, or if they dent the government’s fiscal position or lead to a flight of foreign exchange. From a macroeconomic perspective, the new laws are good, but they’re also too late, so we won’t see significant near-term gains from these. Our short-term forecast won’t change because of them. The impact of these will be long term, and again, a lot depends on implementation.

The government is proposing to overhaul the Customs law to improve trade facilitation. How important is this?
Gomez: The government seems to have a strong commitment to improving trade despite the opposition. The proposed new Customs law is broadly in line with that. They’re also looking at employment and land reforms. The government is looking at trying to make it easier for firms here to employ foreigners. These initiatives are positive, but very challenging.

Panduwawala: There are other reforms on the table, but it requires managing political capital. For instance, the government has expressed an interest in allowing Bank of Ceylon and People’s Bank to list to raise equity capital. Trade unions are likely to oppose this, and if not managed properly, it could lead to strikes and political fallout. Dealing with corruption and investigating the previous regime has political risks, too. Sri Lanka has agreed with the IMF to change the way fuel and electricity prices are determined here, but with elections in 2020, these reforms will have a negative political impact. So 2018 and beyond, the government is beset by political complications.

Gomez: That’s why we say the reforms are also too late, especially after the government has busted a lot of political capital with the bond scandal.

Thilina Panduwawala

Your projections are based on the parliamentary elections due in 2020. What about the local government elections in 2018?
Sanderatne: In 2018, we don’t envisage much. Our base case on the political side is that the government will increase spending and look to build up some credibility leading to the 2020 elections. We are asking investors to look forward to that. We want people to realise that 2019 will be far more definite in terms of the political economy. Consumer demand will surge and government spending will increase. It will be a good year for businesses and the economy. Consumer demand will be good in 2018, but it will be much better in 2019.

What about the reforms?
Panduwawala: Fiscal consolidation may be eased to an extent heading into the elections to shore up electoral support amid the political backlash to certain reforms. The opportunities on the reforms sides will depend overall on how the government manages its now-limited political capital. There are other opportunities, too. On the FDI side, we have the Chinese investment in Port City, which will also attract other investments, and FTAs with a number of countries in the pipeline.

Gomez: China’s ‘One Belt, One Road’ initiative and the fact that it’s increasingly looking for qualitative investment opportunities offshore should be opportunities for Sri Lanka. China is also rebalancing its economy for more consumption-led growth. In this regard, a free trade agreement with China will open opportunities for Sri Lanka, provided businesses are competitive to export there. Another big opportunity is from Chinese tourists. Arrivals from Western Europe have been growing slowly each year. We’re seeing faster growth from East Asia and China in particular.

Panduwawala: On the risk side, there are global risks that could materialise. On one side, there is the global monetary policy carried out by the US Fed and shrinking balance sheets as other central banks fall in line with Fed policy. Over time, that will have an impact on how markets behave. However, for the moment, we don’t expect any global shocks. Global oil prices are increasing. This will have two outcomes for Sri Lanka. First, remittances from the Middle East will stabilise or improve. Second, the import cost will rise, so there won’t be much of a shock. Another risk is the rise in ethnic tension. If this happens, it will considerably erode the government’s political capital and dampen foreign investor sentiments.

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