Srilanka Country Report-2011

ASIA WEALTH MANAGEMENT CO.
(PVT) LTD
SRI LANKA-COUNTRY REPORT 2011
Asia Wealth Management CO. (PVT) LTD | Country Report 2011
Head of Research Saminda Weerasinghe Analysts - Economic Research Umayangana Randeniya Dhanusha Pathirana Analysts - Corporate Research Amali Perera - Senior Analyst Nuwan De Silva Akeela Rasheed Crishani Perera Dilan Wijekoon Minoli Mallawaarachchi Shehara Fernando Nirmala Samarawickrama
Table of Contents
A Precursor Food for Thought" Gross Domestic Product (GDP)
Aggregate Demand and GDP Growth Aggregate Consumption and Investment Employee Income Debt and its Composition
4 6
7 7 8 9
Fiscal Deficit
Transfer Payments
10
11 13
Is Government Spending Unproductive? Analyst Statistics Nuwan Kumara
Inflation
Benchmark rates
15
16 18
Investment Structure and Inflation
Trade balance and the BOP

Remittances The capital and financial account
19
21 25 27
28
Increasing foreign reserves and the exchange rate

REER and NEER
Foreign Debt Factor
29
Employment Generation and Investment Structure

Investment Pattern and Real Wages Quality of Employment Opportunities
30
31 32 33 33
Relationship between Balance of Trade Deficit and Economic Growth Balance of Trade Deficit and Government Finance
The way Forward Sri Lanka
35
Stock Market Outlook Sri Lanka 2010 In Retrospective

2010 New Listings
39
41
Manufacturing Plantations
Rubber Tea Oil Palm
45 46
46 47 48 48
Sector Performance from a stock market perspective
Banking and Finance

Licensed Commercial banks (LCB)
51
51
51
Performance of Licensed Commercial banks (LCBs)
Insurance
Life Insurance General insurance 52 54
52
Leasing Sector Prospects
54
Food & Beverages Land and Property Tourism
55 57 59
7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%
Table 1 - Conflict Years and Pre-Conflict Economic Growth
A Precursor Food for Thought"

26 years of ethnic conflict The year 2010, when the thirty year civil war ended, generated much optimism regarding Sri Lankas economic prospects. The real GNP growth at this time seemed to bear this out. The first nine months of 2010 recorded a 7.9 percent real GDP growth, compared to 3.5 percent in 2009, and as against an expected growth rate of 7.5 percent in 2011. The business conglomerates that incurred losses in 2009 recorded nearly a 50 percent year over year growth in net earnings during the first three quarters of 2010. Having displayed this striking buoyancy the private sector is expected to do even better in 2011. These signs of a turn-around have been widely attributed foremost to the ending of the prolonged civil war. With this presumption there is the hope that the next few years growth rate will increase further, having performed poorly during the war and because of the war. Yet, a comparison with Sri Lankas war time economy hardly provides ground for this optimism which the mere ending of war has generated. Respectable rates of growth were achieved even during the war years of 1983 to 2008. During this 26 year period the average annual growth of the real GDP averaged 5.8 percent, considerably higher than in the twenty one years preceding the war from 1961-1982, when the growth rate was only 3.8 percent (Table 1). In this connection it is also important to note that this commendable growth rate during conflict years was realized even without the tourist boom the offspring of peace- which helped the economy to reach 7.9 percent growth in the immediate postwar year 2010. The relatively high average annual increment in GDP during the war, suggests that growth was not adversely affected by the conflict if growth is measured in conventional terms. It might not be wrong to say that, the economy reaped what may be considered to be a war dividend much larger until now than the peace dividend which was expected to accrue once the war was over. On this reckoning, contrary to what is commonly supposed is borne out: the war had not unduly depressed economic growth, with the economy waiting to take off when peace and political stability returned. The war seemed in fact to have enhanced growth rather than curtailed it.
21 years prior to ethnic conflict

1961-1982
1983-2008
Source: Compiled according to CBSL statistics
Further, the growth of 7.9 percent in 2010 the immediate post conflict year - is only marginally above the average growth rate of 7.3 percent during 2006/2007, the years of intensified fighting (Table 2) and escalating defense expenditure. The GDP growth of 7.3 percent in these two years was all the more notable since it took place after a high-base output growth of 6.2 percent in 2005, as opposed to 2010 in which year the growth performance occurred from a low base of 3.5 percent. Hence, even the average growth rate achieved during the severely war ravaged years of 2006/07, proved to be more robust than that during the postconflict year 2010, allowing for a clear twelve months period.
Table 2 - Conflict Years and Post-Conflict Economic Growth

9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 2006-2007 2010 Source: Compiled according to CBSL statistics
two years of intense war
post conflict period
Gross Domestic Product (GDP)

The year 2010 showed signs of improvement in the Sri Lankan economic outlook as the year witnessed the highest ever recorded GDP growth since 2002 in the 2Q2010 of 8.5 percent. All three sectors of the economy registered significant growth in 2010 over the same period of previous year. The agriculture sector growth was backed by the improvement in global market prices and the upward trend in prices of natural rubber. The agriculture sector growth was further fuelled by increase in paddy and fishing production with the addition of North and East to the rest of the economy. Services sector witnessed a sound performance stimulating economic growth. Food & beverages industry fared better in the light of hotel & leisure sector expansion. Commendable performance was recorded especially in banking & finance, and transportation sectors backed by positive market sentiment. Industry sector performance was affected by the removal of GSP+ tariff concessions coupled with the rising production cost however it was assisted by the increase in demand for semi precious stones, improvement in construction sector, electricity, gas and water. The sector contribution of Agriculture, Industry, and Services to the total GDP in 3Q2010 was 12.0 percent, 28.5 percent and 59.5 percent respectively. The 3Q GDP growth figure was well above expectations of the central bank creating optimism that the momentum would continue well in to next year.
SECTOR CONTRIBUTION TO GDP 2010
12%
Agriculture
59.50%
28.50%
Industry Services
Country Comparison of the Nominal GDP (USD BN) 2010 Est.

-2 0 2 4 6 8 10 12 14 16 18
India, 1430
South Korea, 986.3
Indonesia, 695.1 Taiwan, 427 Thailand, 312.6 Singapore, 217.4 Hong Kong, 226.5 Vietnam, 102 Malaysia, 219 Sri Lanka, 50 Bangladesh, 105.4 Bhutan, 1.397 Pakistan 174.8
Nepal, 15.11 Maldives, 1.433
10.0 8.0 6.0
GDP GROWTH
700
Aggregate Demand and GDP Growth

Increased consumption and investment levels, with a continuous expansion in government spending and a positive net exports balance will cause the rate of growth to rise. On the other hand, with negative net exports, growth to the extent that it takes place, will owe itself primarily to the existing effective demand. If this continues and the market response to it increases as it seems to be doing, the growth will still take place irrespective of export performance, reflecting the production potential of the economy. However, the mechanisms which increase internal demand independently of an external stimulus remain to be explained. This requires disaggregating the GDP into its constituent elements; investment, consumption, government expenditure, and foreign inflows.
REAL GDP (RS.BN)
650
600
%
4.0 2.0 0.0 Q1,09Q2,09Q3,09Q4,09Q1,10Q2,10Q3,10 REAL VALUE OF GDP (RS.BN)
550
500
Source: CBSL
Aggregate Consumption and Investment

Gross Consumption and Investment Total consumption (including government recurrent expenditure) is expected to record in 2010 a 22.5 percent increase to reach approximately LKR 4,845 bn and in 2011 to around 13.3 percent increase to reach LKR 5,487 bn. This indicates the expansionary influence of effective demand in the economy. Investment levels (including government capital expenditure) are also anticipated to increase by 2010 by circa 28.7 percent to reach LKR 1,524 bn and by 2011 to increase around 17.3 percent to reach LKR 1,788 bn depending on the success of the business community in exploiting existing profit opportunities. What appears, however, on the basis of these influences is a low ratio of investments to consumption in the economy. During the period 2003 to 2010 a ratio of investment to consumption of 0.31 demonstrates that consumption growth and the increasing effective demand in the economy were not primarily brought about by rising investments. A huge
investment (LKR bn)
RS BN 6000 5000 4000 3000 2000 1000 0
consumption (LKR bn)
volume of consumption has been sustained with no investment of a proportional magnitude. It reveals that effective demand in the system is derived exogenously through sources outside investments. The windows through which money flows into the economy would help to track down increasing effective demand, given that changes in money supply will directly determine aggregate demand and therefore the growth rate. In this regard, Sri Lankas negative net trade performance explains that money supply is derived from public and private sector wages, credit expansion and remittances rather than from private sector investment or an increase in net exports. We shall identify the windows through which liquidity is pumped into the economy.
Employee Incomes
Real Wages VS GDP Growth
Real wages agriculture
160 140 120 100 80 60 40 20 0
Real wages Industry & Commerce Real wages Services
Statistics compiled by the Central Bank and the Department of Labour indicate a general decline in real wages. In the Agricultural sector from 2002 to 2009 they declined by 13.2 percent, in Industry & Commerce by 2.6 percent. Services sector real wages decreased by a staggering 20.6 percent up to 2006. However, according to CBSL statistics Services sector real wages rose in 2008, but declined by 2.4 percent from 2002 to 2008. A notable fall also occurred in the real incomes of government employees as a whole. Stagnation or a decline in real wages would supposedly constrain consumption expenditures and correspondingly the growth rate and money supply. Yet, the growth rate, the broad money supply and consumption have continued to climb. The total broad money supply (M2) has grown at an annual compound rate of 31.1 percent between 2000 and 2008 from LKR 404.7 bn to LKR 1, 536.8 bn. This is to say money supply has risen despite the stagnation or even relative decline in employee incomes. Evidently consumption rose faster than the volume of real income or GDP growth. The domestic effective demand in the system has expanded independently of real incomes, so that the co-existence of falling real incomes and soaring consumption is to be explained by dissaving: by fixed income earners living beyond their means using borrowed funds. This is to say, the rise in overall consumption and the increasing GDP growth are not supported by real wages, but by exogenously derived money supply made up of consumer debt and foreign remittances.
Real GDP growth
Debt and its Composition

The structure of Sri Lankas commercial banks lending portfolio is revealing in this regard. Trading, consumption and housing in 2010 have absorbed 77 percent of total advances to the private sector and manufacture and agriculture together only 12 percent. A further disaggregation of commercial banks advances to the private sector reveals that Paddy and Apparels have received only 0.63 percent and 6.63 percent, respectively, of the total credit supply, while a new source of consumer credit has come in to being in the form of pawning. Pawning has absorbed a staggering LKR 131.9 bn or 10.23 percent (2.7 percent of the GDP) of total commercial bank advances to the private sector, and is the largest credit absorption ratio by sub categories; all of it is presumably to meet immediate consumption needs. Credit created by pawning is only marginally less than Sri Lankas tea export earnings in 2010 which were LKR 152.1 bn. Also the scale of banking sector pawning more than exceeds twice the total gross tourist income (circa LKR 60.8 bn) in 2010 when there was a surge in tourist arrivals. Sampath Bank, the third largest private commercial bank in the country in terms of branch network and assets recently reported that 23 percent of its total advances were absorbed by pawning and 45 percent of its growth in lending in 2010 was driven by it, indicating that pawning is leading the credit expansion of the economy and has become the main growth area of the banking sector. The non-banking sector inclusive of finance companies and pawning centres has also witnessed an increasing trend in the pawning business. According to CBSL sources, the non-banking sector has undergone a phenomenal growth in pawning activity. Banking sources also reveal that element of risk in pawning is extremely low and more than 97.5 percent of advances made through pawning are redeemed. Although growth in pawning could suggest a situation of economic distress among the marginalized and less privileged with prevailing high inflationary pressures, it also indicates an advantageous situation for the banks given the fact that interest rates in pawning are considerably above the rate of interest on bank loans, resulting higher earnings of the financial sector, contributing to the increasing growth rate. It reveals that pawning is a significant source through which money supply in the system is increasing causing the effective demand and business profits to rise.
Commercial Bank Lending Portfolio

7% 6% 25% 28% 15% 6% 8% 1% Consumption Housing Tourism Industrial Agriculture Financial Trading Other Loans Services
4%
Fiscal Deficit
Country Comparison-Public debt as a % GDP
120 100 80 60 40 20 0
Hong Kong Singapore South Korea Taiwan Vietnam Indonesia Thailand Malaysia Sri Lanka Bangladesh Bhutan India Pakistan
A continuous fiscal deficit creates fundamental macroeconomic imbalances particularly for a developing nation hence taming the fiscal deficit is a key objective in sustaining macroeconomic stability of a country. In 2010 Sri Lankas government deficit for the period January to November 2010 stood at Rs 409.8 bn down by 5.27 percent when compared with the figure of Rs 432.6 bn recorded for the same period in 2009, indicating an encouraging outlook towards attaining long term macroeconomic stability. The total revenue recorded an increase of 14.43 percent amounting to Rs. 749.3 bn from Rs. 654.8 bn recorded for the same period in 2009 and the tax revenue grew by 16.74 percent to Rs. 654.6 bn from Rs. 560.7 bn accounted for in the corresponding period of 2009. This was largely due to the increase in imports fuelled by the reduction in import duties especially on motor vehicle importation. The total expenditure for the ten month period grew by 6.59 percent amounting to Rs. 1159.1 bn compared to Rs. 1087.4 bn recorded for the same period in 2009. Recurrent expenditure during the period increased by 3.11 percent to Rs. 852.9 bn from Rs. 827.1 bn while capital expenditure increased by 17.67 percent to Rs. 306.2 bn from Rs. 260.2 bn. The fiscal deficit figure for the first 11 months of 2010 reached 7.34 percent of GDP well within the IMFs recommended target deficit rate of 8 percent of GDP. The government has made significant fiscal reforms to attain fiscal consolidation in its 2011 budgetery proposals. In this regard the government imposed major changes in taxation and transfers as a measure of curbing the trade deficit while assisting the private sector in achieving macroeconomic challenges. Altering of the tax system seems pro investor as well as pro consumer as the reduction of direct taxes on income, profits and consumer items will encourage more spending and investment in the economy. Furthermore the reduction in tax rates would enable the government to increase revenue despite reduced tax rates as the expansion in the tax base would increase the tax revenue collection. The reduction in budget deficit from 9.9 percent recorded in 2009 to 7.34 percent signals that the government is stepping in the right direction.
Public debt levels as a % GDP

5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 1990 2002 2003 2004 2005 2006 2007 2008 2009 2010 Public debt (LKR bn)(RHS) Debt (% of GDP)- (LHS) 120 100 80 60 40 20 0
LKR BN
10
Nevertheless,addressing the fiscal imbalance remains to be a complex and a sensitive issue which ought to be dealt with extra diligence. While adhering to IMF requirements any comprehensive measure which aims at altering the distribution of resources should render special attention to the socio-economic and political impacts.
The major tax reforms and subsidies of Government budget 2011 The exemption of PAYE tax for annual incomes less than LKR 600,000. Decreasing the corporate tax from 35percent to 28percent. Reduction of income tax on Venture capital corporations up to 12percent. Exemption of Economic Service Charge for investment trusts. Reduction of Value Added Tax (VAT) from 20percent to 12percent for financial services. Removal of the Social Responsibility Levy. Imposing CESS on primary goods and raw material exports.
Fiscal Performance
12 10 8 6 4 2 0 1990 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010P 2011E 25 20 % 15 10 5 0
Fiscal Deficit -% GDP (LHS)

Source: CBSL
Revenues/GDP (%) (RHS)
Is
Is Government Spending Unproductive?

Increasing fiscal deficits have been widely regarded as the fundamental cause of current price inflation in Sri Lanka which is a growing concern to the public and the policy makers. Also Central Bank opting to print money in order to finance deficits of successive governments is believed to be a main catalyst driving inflation. However, the CBSL statistics indicate that the increase in broad money supply owing to the increase of CBSLs net domestic assets by providing provisional advances to the government remains at insignificant levels. The annual average amount of CBSLs advances to the government over the past ten years is only LKR 3.8 bn; and compared to the extremely high inflation rates witnessed by the economy over corresponding period, the figure of LKR 3.8 bn turns out to be highly extraneous. Furthermore, CBSLs provisional advances to the government as a percentage of the fiscal deficit over the past decade are demonstrating an extremely low rate averaging 1.6 percent. Hence, the conventional notion that monetary authority of the country opting to
11
print money to finance fiscal deficits is causing inflation appears extremely unsubstantiated.
Government debt mix as a % GDP

External Government Debt Domestic Government Debt
42
54
58
58
59
55
52
50 38
2006
48 37
2007
48 33
2008
50 37
2009
44 38
2010
55
43
2000
45
2001
45
2002
46
2003
48
2004
39
2005
1990
Sources: CBSL
Government Expenditure as a % GDP

External Government Debt Domestic Government Debt
42 55
54 43
58
58
59
55
52 39
50 38
48 37
48 33
50 37
44 38
45
45
46
48
1990 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: CBSL
Therefore, an alternative explanation is required to illustrate the real factors which influence a general rise in price levels. The commodities which have increased in price are the essential items such as food, crude oil, transportation and power while the price of non-food articles and services such as consumer durables, communication, other electronic items and motor vehicles have decreased. Considering the inflexibility of demand due to natural limit in amount an individuals consumption of essential food in a fixed period of time, the notion that increasing government spending exerts upward pressure on the price of rice or vegetables appears unrealistic. According to the statistics of the UN Food& Agricultural Organization, from 1998 to 2004 Sri Lankas per capita rice consumption fell by 0.79 percent.
12
Therefore, the relationship between rising food prices and government spending remains questionable. More importantly, if government opts to reduce spending by scaling down on healthcare, economic services and public education, its recurrent and capital expenditure will decrease leading to a budget surplus. Yet, such a move will raise the market price of the services mentioned as the private sector will now provide them with an unsubsidized price tag. Consequently, inflation levels will rise reducing the already rigid real wages. With this aggregate demand in the economy would deteriorate dragging down the real GDP growth rate. It will further, increase unemployment by nearly 10.1 percent since the private sector is not experiencing a crowding out effect of labour by government provided employment opportunities.
Central Bank advances to the Government and Inflation

20.0 15.0 10.0 5.0 5.0% LKR bn 0.0 2000 -5.0 -10.0 -15.0 Central Bank Advances to the Government (LKR bn) Central Bank Advances to the Government as a % of fiscal deficit Annual average inflation Source: Compiled according to CBSL statistics 2001 2002 2003 2004 2005 2006 2007 2008 2009 0.0% -5.0% -10.0% -15.0% Sources: CBSL 25.0% 20.0% 15.0% 10.0%
Transfer Payments
The role of transfers also seems to resemble an interesting correlation with current price inflation and GDP growth. The government subsidies on rice, electricity, fertilizer and crude oil absorb part of the increasing cost of production of the private sector. Unlike non-essentials, the rise in prices of these articles is likely to create a ripple effect in price increases as they directly bear on the production process of a large complex of goods and services. Although world market price of crude oil rapidly increased over last two years, the government to a considerable extent has prevented a contagion effect on domestic price levels and kept inflation substantially below the level it would prevail under uninterrupted functioning of market forces by subsidizing the prices. Consequently, the graph below demonstrates an inversely related movement between Sri Lankas point-to-point inflation and world market crude oil prices; in the absence of a transfer it would have indicated a positive movement.
13
Crude Oil prices vs Inflation

$120.00 $100.00 $80.00 $60.00 $40.00 $20.00 $0.00 Aug-09 Mar-09 Mar-10 Aug-10 Jan-09 Jan-10 Oct-09 Nov-09 Dec-09 Oct-10 Nov-10 May-09 May-10 Dec-10 Feb-09 Apr-09 Sep-09 Feb-10 Apr-10 Sep-10 Jun-09 Jun-10 Jan-11 Jul-09 Jul-10 30 25 20 15 10 5 0
Sources: CBSL
Crude oil price per barrel
Point to Point Inflation
Hence, the principal function of government transfers is achieving a stable monetary stance by holding back the flood waves of world inflation which threaten to breach the domestic sphere through humongous fury of foreign goods flowing in to the country. These government transfers are holding down the cost of production of the private sector and thereby increase its competitive power above the level which would prevail under normal market conditions. Under this back drop, any form of scaling down of welfare expenditure would go hand in hand with a destabilization of the economy by lowering the effective demand in the system. Hence, the profit margins of the business community would fall, subjecting the economy to disorder if government, like the private sector, considers itself to be a profit generating institution. Finally, if welfare spending is reduced to the pattern mentioned earlier, government will suspend domestic borrowings owing to its increased revenue. The risk free interest incomes -in the form of government domestic interest payments- of individuals and the financial conglomerates which amounted to circa LKR 274 bn in 2009 (5.7 percent of GDP) will then be wiped out. This will hold true as there is no crowding out of credit to the private sector by large-scale government borrowing as is evident from the countrys low investment to consumption ratio (0.31) and the reduction of policy rates by 25 and 50 basis points respectively by CBSL in order to activate or mop up unemployed capital of circa LKR 140 bn. In fact deficit spending preserves the capital value of the surplus by activating the unemployed capital unabsorbed by private investments. Although it is creating inflationary pressures in the economy it has the positive aspect of maintaining aggregated demand, making fiscal deficit a mixed blessing for the private sector.
14
Inflation
Inflation has witnessed a gradual increase in year 2010. The year started with an annual average of 3.1 percent which gradually climbed to 5.9 percent in December 2010. The low inflation levels at the beginning of the year was due to contraction in demand prompted by declining external reserves and the global economic downturn .However with the gradual increase in global food prices, point to point inflation for the month of December 2010 stood at 6.9 percent. The annual average inflation which has been hovering over 5 percent since August 2010 reached 5.9 percent by December 2010, the highest reported since reaching 3.1 percent in January of the same year. The increase was largely due to supply side constraints in the world food production and local supplies which led to the increase of most food prices such as rice, vegetables, sea food and sugar. Food imports account to circa 14 percent of the total import cost of the country, therefore the increase in the import cost of staple food items will continue to widen the impact of imported inflation in the domestic sphere. The supply constraints are worsened by the rise in oil prices towards the latter part of 2010 which exerts pressure on production costs. The soaring food prices due to supply constraints together with the rising capital inflows to the country could further exert upward pressure on inflation; however the Central Bank anticipates the inflation to be contained within single digits in 2011.
Country Comparsion-Inflation rate(%)

15 10 5 0
Inflation
235 230 225 220 215 210 205 200 195 190 185 Mar-09 Mar-10 Nov-08 Nov-09 30 25 20 15 10 5 0 -5
CCPI Index
Aug-10
Aug-08
Aug-09
Jan-09
Dec-08
Dec-09
Jan-10
Nov-10
May-09
May-10
Index
Monthly Change
Point to Point Change
Annual Average Change
15
Dec-10
Sep-08
Oct-08
Feb-09
Apr-09
Sep-09
Oct-09
Feb-10
Apr-10
Sep-10
Oct-10
Jun-09
Jun-10
Jul-09
Jul-10
Benchmark rates
The Central bank eased benchmark rates gradually throughout the year taking advantage of the low levels of inflation which prevailed in the first half of 2010 .The reduction in rates were mainly aimed at spurring private sector investment as a means of stimulating economic growth.
LKR BOND RATES 25 20 15 1YR Maturity 2YR Maturity 10 5 0 3YR Maturity 4YR Maturity 5YR Maturity 6YR Maturity
Source: CBSL
Concurrently, the four year benchmark yield rate which stood at 9.78 percent in January 2010 was slashed to a low of 9.09 percent by August, 2010 and was further reduced to 8.20 percent by January 2011. Furthermore; The inadequate growth in export earnings, together with the discontinuation of the European Union export concessions prompted the central bank to reduce borrowing costs of private sector in order to bring down cost of production and increase export sector competiveness in global trade. One of the biggest obstacles to private sector led economic expansion was the high interest rates prevailing in the country as it invariably increases cost of capital. Hence the move was encouraging to the private sector and consequently the private sector loan book expanded by 31 percent in the final half of 2010. Sri Lanka however was in contrast with most other parts of the world as many countries borrowing rates such as India, Thailand, Malaysia and China witnessed a gradual increase in order to curb rising inflation. In addition The US and the Euro Zone also faced high yield rates as the risk of uncertainty hovered over most of the western economies.
16
Benchmark yeilds
25
Jan-11
20
Dec-10
15
Nov-10 Jul-10
%
10
Dec-09
5 0 1YR Maturity 2YR Maturity Source: 3YR MaturityCBSL 4YR Maturity 5YR Maturity 6YR Maturity
Jul-09 Jan-09
Nevertheless domestic inflationary pressures gradually increased towards the latter part of 2010 and the rising food prices compelled the government to reduce tariffs of essentials such as milk powder and crude oil which will have to be continued well into the near future. Such costly measures coupled with the reconstruction expenditure incurred due to the recent adverse weather conditions which prevailed in the latter part of 2010 would further augment government expenditure resulting in further increase in government domestic borrowings. This coupled with the possible upward revision in tax rates to mitigate the additional government expenditure could further exert inflationary price pressures, therefore; The central bank will take a cautious stance with regard to policy rates and will be compelled to conduct monetary policy carefully in order to keep inflation within single digits while sustaining economic recovery .In this regard it is highly likely that the borrowing rates would remain stable throughout 2011.
Policy rates and Benchmark rates vs Inflation
25 20 15 % 10 5 0 Feb'09 Apr'09 May'09 Jun'09 Sep'09 Nov'09
Annual Avg.Inflation
Jul'10
Aug'10
Jan'11
CBSL Repo Rate
CBSL Reverse Repo Rate
Bond Yeilds at 4YR Maturity
Source: CBSL
17
Investment Structure and Inflation

Inflation is viewed by economists as a monetary phenomenon emanating from growth in money supply when Central Bank of the country opts to finance fiscal deficits through provisional advances, increasing Central Banks net domestic assets. The credibility of this explanation was briefly examined in the previous section. In the proceeding segment, inflation will be very briefly reviewed in terms of the structure of the prevalent capital formation in the economy. The spheres of investment in the economy dominated by imports trade do not allow the decrease of production costs through increasing labour productivity by replacing capital for labour. Owing to this fact the degree of increase in productivity of labour in the economy and the reduction in production costs by means of a substitution of capital for labour has been insignificant. This particular characteristic of investments effectively precludes economies of scale of a decreasing unit cost of production. Entrepreneurs are thus compelled to raise the market price of goods and services in order to increase business profits causing the price of imported material to increase independent from exchange rate fluctuations. This is a deciding element governing the inflationary pressures prevalent in the economy. The allegation that a Trade Lobby is controlling the prices of essential products is therefore, not a phenomenon limited to the growth of monopoly power, but is essentially related to the limited cost reduction options which govern spheres of investments. Hence, it is not the increasing supply of money as an abstract category that is forcing the prices of essentials to escalate but the concrete nature of money supply growth or rather the type of activity which essentially increases the supply of broad money which increase inflation. In fact the growth of money supply has the tendency to reduce inflation if the additional supply of cash was directed to investments which allow reduction of production costs through increased capital formation.
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Further, the fall in real incomes owing to the inflationary pressures emanating from the structure of investments has a tendency to increase demand for consumer debt which is demonstrated by the staggering growth of advances by commercial banks in the form of consumer loans. Therefore, inflation has also unlocked a vast new sphere for lending for financial institutions which positively contributes to their earnings growth as well as to countrys high growth rate. If we may repeat, the increase in the growth rate is not a consequence of permanent ending of war but of the peculiarity of investment pattern and the consequent expansion of consumer debt.
EXPORT COMPOSTION
Tea
Trade balance and the BOP

Sri Lanka experienced a continuous rise in import expenditure unmatched by a corresponding growth in export earnings throughout 2010. The cumulative earnings from exports during the year 2010 increased by 17.3 percent YoY to USD 8,307 mn, while the cumulative expenditure on imports during the corresponding period increased by 32.4 percent YoY amounting to USD 13,512 mn. As a result, the trade deficit expanded by 66.7 percent to reach USD 5,204 mn during 2010 compared to USD 3,122 mn recorded for 2009.
USD MN 20,000 15,000 10,000 5,000 0
17% 30% 2% 2% 4% 1% 3%
Rubber Coconut Minor Agri Products Gems Petroleum products
41%
Textile & Garments Other Industrial exports
Imports & Exports VS Trade Balance
Export Composition of Singapore

2% 2% 1% 7% 11% 67%
Manufact.
-5,000 -10,000
2000
2002 EXPORTS
2004 IMPORTS
2006
2008
2010(a)
TRADE BALANCE
10%
Fuels Minerals Transport Travel other Agro
The import base of Sri Lanka mainly consists of commodities with a relatively inelastic demand such as crude oil and food imports which account for 39 percent of total imports. However the major exports on the other hand mainly comprises of primary commodities with a relatively elastic demand making the country highly vulnerable to price volatilities of the global market. Furthermore; Sri Lankas export base is composed of primary goods such as tea and rubber which bear technologically stagnant production practices relative to the industrialized economies of the developed world. In addition the garment exports although accounting for 41 percent of the total exports are more of a bulk export with relatively low levels of technological sophistication, hence not creating a niche in the world
19
market. This is in contrast to the emerging Asian economies such as South Korea, Malaysia and Singapore which achieved rapid export led economic growth, with more than 60 percent of exports consisting of commodities with high levels of technological sophistication such as motor cars, electrical appliances and computer hard ware. Sri Lanka remains concentrated on export sectors with lower technological intensity therefore generating extraordinary lower incomes. Thus, a structural change in the export composition in favour of technologically progressive industries is imperative to address the deteriorating trade balance of Sri Lanka.
Country Comparison- Total Export Value (USD BN)
South Korea, 466 Singapore, 358 Hong Kong, 383 Taiwan, 278 Malaysia, 193 India, 201 Thailand, 191
Indonesia, 146 Vietnam, 71 Pakistan, 20 Sri Lanka, 8 Bangladesh, 16 Bhutan, 1 Nepal, 1
Source: Compiled according to the statistics of CIA World Fact book and The World Bank
In addition, Western countries continue to be the major destination for Sri Lankas exports. Europe and U.S.A together account for 60 percent of countrys exports. Hence the recent unfavourable economic conditions prevailing in the US coupled together with the sovereign debt crisis of Euro zone could negatively impact the export earnings of Sri Lanka. The expected reduction in export earnings coupled with the expected rise in all segments of imports fuelled by the increase in consumption is most likely to continue to negatively affect the trade balance well in to the next year.
20
60 40 20 0 -20
Remittances Country Comparison-Current account Balance (USD BN)
Source: Compiled according to the statistics of CIA World Fact book and The World Bank -40
Remittances
The increase in the flow of remittances greatly assisted to ease the pressure on the current account triggered by the increase in the unfavourable position of the trade balance. Private remittances continued its favourable trend recording a significant growth of 21.9 percent during the course of January to October 2010. Inflow of private remittances for the first ten months of 2010 marked as USD 3,380.4 mn relative to the USD 2,773.8 mn recorded in the corresponding period of 2009. Workers remittances are expected to exceed USD 4.1 billion in 2010, up by 24 percent from previous year .The Current account deficit expanded to USD 935mn by September 2010 (provisional) already surpassing the deficit figure of USD 214 mn recorded for the year 2009 by more than four folds.
USD MN 6,000 4,000 2,000 0 -2,000 -4,000 -6,000 -8,000 TRADE BALANCE Source: CBSL REMITTENCES
REMITTENCES VS TRADE BALANCE
The heavy dependency of Sri Lankas economy on foreign remittances with respect to effective demand is continuously being highlighted by economists. In the proceeding section, the factors which fuel the growth of remittances and their macroeconomic implications will be briefly reviewed in terms of the investment structure of the economy. The total earnings Sri Lanka received via remittances in 2010 is approximately USD 4175 mn, the magnitude is so large it exceeds seven times the gross foreign exchange income from tourism (circa USD 547 mn) during the same period which saw a massive surge in tourist arrivals. Since no production costs are involved in departures foreign employment
21
does not induce an outflow, and hence, the net foreign exchange income of tourism which is below the gross level would further increase the above multiple. In this connection, growth of remittances stands as the significant non-debt driven inflow increasing the effective demand and business profits and relieving Sri Lankas expanding trade deficit. Foreign employment ranked as the fifth largest contributor to foreign exchange earnings in 1990 and since then, it has become the premier net foreign exchange earner in Sri Lanka from 2009 onwards. The percentage of total exports to private remittances was 20.9 percent in 2000 and is as high as 51.8 percent in 2010 (annualized) indicating that the growth of remittances has outpaced the increase of exports. This means the importance of the entrepreneur is relatively substituted by (mainly) housemaids in increasing foreign exchange income of the economy. Remittances VS Exports income
9,000 8,000 7,000 6,000 USD MN 5,000 4,000 3,000 2,000 1,000 0 60 50 40 30 20 10 0
Exports( USD MN)
Remittances( USD MN)

Source: SLBFE
Remittances as a percentage of exports income
Considering foreign employment by the manpower categories involved, housemaids continued to be the largest category among migrant workers. Out of the total females who left the country in search of employment 89 per cent were housemaids who are a poorly paid manpower category with no bargaining power in labour markets. In spite of these hazards Sri Lankans continue to migrate in search of employment as a measure of last resort. Major factors that influence Sri Lankans to work abroad even under these conditions are stagnant real incomes, unemployment/underemployment, high inflation, indebtedness, and a virtual inability to exist in the home country. The growing remittances are conventionally regarded as an achievement when they are an indicator of increasing employment issues, falling real wages and indebtedness. An aggravation of these conditions has a tendency to increase the rate of departures and the foreign employment income of the country, demonstrating a positive link between the growths of remittances and the inadequate demand for labour in the economy. This increasing restraint to absorb the labour force is the outcome of the investment patterns explained earlier.
22

30
Foreign employment data - Comparative growth patterns

25 20 15 10
%
5 0 -5 -10 -15 % of labour force growth % of foreign employment growth Source: CBSL & SLBFE foreign employment as a % of total employment 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Evidence of the low absorption rate of the work force is shown by the extremely high percentage of migrant workers compared to the total employed population of the country. The figure has increased to staggering 25.9 percent in 2010 which stood at 13.5 percent in 2000. Nevertheless, concomitant with a low labour absorption rate, the private sector conglomerates as mentioned earlier, have witnessed a surge in net earnings and the trend is expected to continue undeterred. This coexistence of expanding profits and insufficient level of labour absorption demonstrates that in spite of the fact that resources of the country are underutilized corporate profits are set to rise. It illustrates that the increase in business profits is continuing to advance relatively independently from the levels of employment generation; this has a tendency to increase the deterioration of the latter by investments continuing to flow in to the same limited unproductive spheres. It also points to the positive link between increasing profits and consumer debt causing the growth rate to rise while economic resources remain underutilized. In this connection it should also be noted that the expanding export of labour has obscured the real unemployment levels as given in official statistics. A comparison of the data compiled by Department of Census and Statistics and Foreign Employment Bureau show a strong inverse correlation between countrys official unemployment rate and the growth of foreign employment as a percentage of total employment (FEPE). In 1993 the official unemployment rate was high as 13.8 percent which stood significantly above FEPE figure of 8.8 percent.
23
Throughout the course of past 17 years the official rate of unemployment has effectively declined and currently stands at 4.9 percent, while the FEPE figure has moved to 25.9 percent exceeding the rate of unemployment by a great margin. Inverse correlation between Foreign employmemt growth and Unemployment rates
30 20
%
10 0 foreign employment as a % of total employment
Unemployment rates
Source: Compiled according to Foreign Employment Bureau and Department of Census and Statistics
More importantly, the escalation of this disguised-unemployment in the economy has been the major source of relief to the increasing trade deficit and boosting domestic aggregate demand; it has reduced unemployment while demand for labour remains inert. Growth of this disguised-unemployment increases the purchasing power of less privileged in spite of the general fall in real wages noted earlier. It would thus seem that the increase in this disguised-unemployment and stagnant real incomes cause the rate of growth to rise indicating an unemployment-led growth pattern in the country instead of an exportled development.
24
The capital and financial account

The FDIs have been on a declining trend since 2008. FDI in the first half of 2010 contracted to USD 208 mn. Meanwhile, the FII(Foreign Indirect Investment) in the form of short term funds in the Colombo bourse, increased from circa US$ 315 mn in 2009 to a forecasted figure of staggering circa US$ 1,110 mn for 2010 (+ 254.6 percent YoY). This observation indicates a fundamental shift of foreign investor patterns in Sri Lanka from direct to indirect investment. It implies that foreign ownership of financial assets is growing at a rate faster than the foreign ownership of real assets, signaling a financialisation of foreign capital accumulation in Sri Lanka. Most importantly, this fundamental shift of foreign investor pattern from FDI to FIIs would not assist the realisation of desired outcomes of Sri Lankan government which is currently aiming at rapid economic development.
USD MN 800 600 400 200 0

1995
1990 1991 1992 1993 1994 1996
FDI (NET)
2006
1997
1998
1999
2000
2001
2002
2003
2004
2005
2007
2008
2009
Source: CBSL
However; it is expected that the 2010 pro investor budgetary proposals introduced by the government, together with the renewed investor confidence of Sri Lanka, and the development of North and East would gradually improve FDI flows to the country to reach circa USD 700 mn by the end of 2011(IMF estimates).The development of North and East would further improve FDI flows to the country.
FDI CLASSIFIED BY COUNTRY OF INVESTMENT (JAN-SEP 2010)

India Malaysia
FDI-SECTOR CLASSIFICATION (JAN -SEP 2010)

Manufacturing 13% 31% 17% Agriculture InfrastructureTelephone, Telecommunicat ion & Network Infrastructure-other Services
22% 4% 5% 6% 10% 13%
22%
UK U.A.E.
18%
Hong Kong Mauritius Netherlands Other 37% 2%
Source: Compiled according to the statistics of BOI Sri Lanka
25
2010Est.
The foreign financial flows to government in terms of treasury bills and bonds increased in the first eight months of 2010 amounting to USD2, 246mn.The external debt servicing cost as a percentage of exports income fell from 17.2 percent in first half of 2009 to 11.7 percent in the same period of 2010. Hence, despite the trade balance remaining in negative territory the overall BOP recorded a surplus of USD 1.3 bn for the first ten months of 2010 backed by the higher foreign inflows in terms of foreign debt and portfolio inflows.
USD MN 6000 4000 2000 0 2005 -2000 -4000 -6000 -8000

TRADE BALANCE REMITTENCES
EXTERNAL SECTOR OUTLOOK
% 20 18 16 14 12
2006
2007
2008
2009
2010(a)
10 8 6 4 2 0
FDI
NET GVT. INFLOWS
BOP SURPLUS
DEBT SERVICE RATIO
26
Increasing foreign reserves and the exchange rate

The year 2010 witnessed a significant inflow of foreign reserves .The gross official reserve which fell to a low of USD 1272 mn (sufficient for a mere 1.2 months of imports) at the beginning of year 2009 exceeded USD 7 bn by end of 2010. The total reserves for November 2010 stood at the equivalent of 6.1 month of imports.
Country Comparison-Total Foregin reserves (USD BN)

500 400 300 200 100 0
Source: Compiled according to the statistics of CIA World Fact book and The World Bank
With a strong foreign reserve base that exceeds USD 7 bn, Sri Lanka was in a position to relax foreign exchange controls with the objective of further expanding the economy injecting more foreign capital especially into the equity and debt market. The sovereign bond issue which took place in September 2010 was oversubscribed by 6 times clearly emphasizing the restored foreign investor confidence bringing in a further inflow of USD 1 bn sharply increasing the foreign reserves. The IMFs further disbursement of USD 212.5 mn in October 2010 under its standby arrangement bringing total disbursements under the arrangement to an amount equivalent to USD 1,274.8 mn, the improving sovereign ratings, coupled with the rising remittances throughout the year further increased the foreign inflows to the country. Such developments and the depressed US economic conditions together with the Euro Zone sovereign debt crisis have appreciated the LKR against other currencies. The rupee appreciated 2.2 percent against USD and 7.4 percent against the Euro by end Sep2010. However the appreciation of the rupee is by and large due to the Capital account of the BOP as the Current account continues to deteriorate amounting to a trade deficit of USD 4,039 mn during the first 10 months of 2010. The Central Bank intervened and mopped up the excess volatility by way of net absorption of USD 241 mn in September 2010 as a measure of retaining export competitiveness. An appreciating rupee creates mixed macro economic consequences. On one hand it would deteriorate the export competitiveness, and negatively
27
affect the tourism industry as tourist interest would shift to cheaper destinations. On the other hand currency depreciation could worsen the foreign debt burden as debt servicing cost increases with depreciation. A stronger currency would reduce the price of essential food items and reduce the cost of living of an import dependent economy. However, the reducing cost of imports will increase the demand for foreign goods, creating upward pressure on the trade deficit. Furthermore the considerable build up of foreign reserves will increase the ability to withstand external shocks. Therefore the currency appreciation cannot be solely viewed from the competitiveness angle and the prevention of creating imbalances to the rest of the economy should be taken in to consideration. Although Sri Lankas trade deficit continues to be in negative territory, it is expected that the LKR would continue on an appreciating trend gradually by 2 percent-3 percent over 2011 with the increase foreign investor confidence which would further increase foreign inflows to the country.
REER and NEER

The balance of trade deficit is expected to reach circa USD 5,175.2 million in 2010 widening the gap between Real Effective Exchange Rate (LKR 123.17) and Nominal Effective Exchange Rate (LKR 89.7). A sudden withdrawal of foreign portfolio investments and a divestment of government securities by foreign holdings will exert upward pressure on REER and NEER. And the gap between REER and NEER will decline sharply with real exchange rate increasing to reach the nominal exchange rate figure. Consequently, the rupee cost of imports would build up inflationary pressures in the economy and raise the governments external debt servicing cost, thereby widening the fiscal deficit.
150 Index Points No. 100 50 0 2009 Aug Sep Oct
Effective Exchange Rate Indices: 24- Currencies (2006=100)
NEER REER
Nov
Dec
2010 Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
28
Foreign Debt Factor

However, domestic credit will not rise in the face of a declining external reserves and a lack of access to foreign capital markets. It is governed by a corresponding expansion of foreign debt to maintain rising consumption based on foreign goods. For instance, the sudden spurt of activity from the beginning of 2010 was preceded by a period of escalating economic turmoil where first two quarters of 2009 recorded negative real GDP growth and foreign reserves of the country watered down to levels below USD 1.4 bn while exchange control measures increased, lowering effective demand in the economy, and notably curtailing domestic credit expansion. However, the approval of USD 2.6 bn IMF Stand-By Arrangement (SBA) in June 2009 which amounts to nearly 400 percent of the official quota allocated for Sri Lanka, improved the countrys growth prospects. This made the foreign capital markets willing to provide loans to the government at low risk premiums, and with the borrowed funds and portfolio inflows Sri Lanka managed to tide over its FOREX problems from July 2009 onwards. Although IMF money is not obtainable, and is not utilizable to settle balance of payment dues, the Funds presence itself created space for the government to sell bonds and to publicize the positive prospects of the economy to draw in foreign direct and portfolio inflows. The IMF has become an unofficial guarantor of sorts until Sri Lanka is able to attract foreign inflows on its own. Much more than the credit Sri Lanka is receiving from the IMF, its presence instilled in investors, the comfort and credibility to invest in government bonds and in the stock exchange. With borrowed funds and portfolio inflows external reserves improved dramatically and sustained a volume of imports without a corresponding improvement in exports, thus widening the balance of trade deficit; as a result, the growth rate started to rise significantly to reach 7.9 percent in the year 2010.
USD MN 8,000 6,000 4,000 2,000 0
Gross Foreign Reserves increasing subsequent to the IMF SBA
IMF SBA
During the course of last ten years the foreign debt has nearly quadrupled; from approximately LKR 542 bn in 2000 to above LKR 1,950 bn in 2010.
29
Government Foreign Debt

2500 2000 LKR BN 1500 1000 500 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 E 60 50 40 30 20 10 0
Government foreign debt (LKR bn) Source: CBSL
Foregin Debt as % of GDP
Nevertheless, the increase in growth rate and the stagnation of real incomes will continue to rise simultaneously, given liberal external and domestic financing to sustain the investment pattern. The relationship between investment structure and expansion of external and consumer debt will be reviewed in the proceeding sections.
Employment Generation and Investment Structure

These lending patterns are linked with the negative trade balance and to huge portion of credit that has been allocated for import-led consumption purposes rather than for productive investments. The fact that trading, consumption and housing in 2010 have absorbed 77 percent of total advances to the private sector and pawning has absorbed 10.23 percent demonstrates that consumer debt has undergone a staggering growth, superseding the flow of credit into production. With a low level of productive investments in the private sector demonstrated by the low percentage of advances to manufacturing- credit growth has been primarily consumption driven alongside relatively low investment expenditure. This pattern of capital formation and the corresponding banks lending structure weakens the economys potential to expand employment. On the other hand, it carries with it the tendency to increase unproductive credit growth in the economy which has a propensity to affect productivity and the competitive levels. The expansion of financial & non-financial services, primary products such as garments and plantation crops and its connection with the low investment to consumption ratio in the economy is important in illustrating the factors which weaken the economys potential to generate productive employment. Compared to industrialized economies the expansion of services, import trade and primary products do not require the entrepreneur to incur large-scale fixed capital investments. Demand for large scale fixed capital investments in the nonmanufacturing sector remains considerably low. This exceptional attribute of services as also of primary products lowers the investment to consumption ratio of the economy despite investments are taking place. This is demonstrated by the high unemployment rate of capital
30
demonstrated by the excess liquidity of over LKR 140 bn weakening the volume of employment of labour even when loans growth of commercial banks is exceeding 26 percent. Excess liquidity in the system is two times more than the gross tourist income in 2010 and is 10.9 percent of commercial banks total advances to the private sector and could be noted as the rate of unemployment of capital. Hence, the investment structure indicates a lack of qualitative aspects required to generate employment. A recent World Bank report on youth unemployment in Sri Lanka provides details supporting the above argument. Youth unemployment -representing the most productive segment of the workforce- was nearly 80 percent of all unemployed in year 2006. The information provided by the Department of Census and Statistics shows much the same trend. Overall unemployment for those between the ages of 15 to 24 and 25 to 29 is 21.3 percent and 10.3 percent respectively, and youth unemployment is more than six times that of the adult unemployment.
Investment Pattern and Real Wages

The investment structure comprised of services, import trade and primary products with a minimal of fixed capital bears a low tendency to increase labour productivity through scientific and technological advances. Hence, the expansion of the prevailing investment structure undermines employment creation and real wage growth, compared to industrialized economies. The general stagnation in real wages noted earlier can be attributed to the prevailing pattern of investments of the entrepreneurs and this has a tendency to increase demand for consumer debt making the latter a significant source of net earnings of conglomerates and real GDP growth. A revealing comparison is with the real wages in China and India since 2003 both of which recorded an increase of 40-50 percent while in Taiwan during the last ten years real wages increased by 17.5 percent and in Singapore during 2006 and 2007 real wages rose by 10.4 percent. The investment to consumption ratio in China, Taiwan and Hong Kong was 0.9 in 2008 and is showing an upward trend, indicating the growing fixed capital formation centering around industrialization.
Investment/Consumption ration Sri Lanka VS Taiwan

investment/consumption ratio SL 0.79 0.82 investment/consumption ratio Taiwan 0.85 0.86 0.9
0.72
0.26
0.3
0.33
0.34
0.34
0.32
2003
2004
2005
2006
2007
2008
Source: Compiled according to CBSL and National Bureau of Statistics China
31
Quality of Employment Opportunities

The choice of services, import trade and primary products as an area of Investment means an employment creation of low profile type; as the provision of services and primary products is technologically stagnant, demand for high skilled employees in the economy remains ossified. Hence, creation of employment remains qualitatively inferior. Approximately 70 percent of the work force has not received education beyond grade nine and the tertiary-educated workers are merely 1.6 percent of the total work force. Unemployment among graduates is exceeding 25,000 and latter as a percentage of tertiary-educated workers in the country is 19.5 percent. According to 2008 Labour Ministry Survey, the average employment rate for graduates one year after completing their studies demonstrated a low trajectory of 38.9 percent while out of the total employed workforce 61.9 percent is informally employed with neither any job security nor a possibility to advance their pay. In contrast, the tertiary-educated workers in Singapore have grown from nearly 25 percent in 1990 to nearly 33 percent in 2010. In United States of America the figure stands close to 36 percent (Monetary Authority of Singapore MAS- Annual Report 2009/2010). These facts indicate that the pattern of investment in industrially mature regions generates qualitatively superior employment with higher incomes relative to nonindustrialized economies.
Source: MAS Annual Report 2009/2010
0
45 40 35 30 25 20 15 10 5 0 -5
Tertiary-Educated work force as a2percentage of total work force 2009/2010 0.5 1 1.5 2.5 3 3.5
Sri Lanka Singapore USA
32
Relationship between Balance of Trade Deficit and Economic Growth

The relationship between the trade deficit and the rate of growth provides vital insight concerning the patterns of economys intrinsic functioning. The widening of trade deficit demonstrates a corresponding increase in the real GDP growth indicating a positive link between the rate of growth and the expansion in balance of trade deficit, provided that sufficient gross external reserves exist. This is to say, an increasing growth rate goes hand in hand with a growing trade deficit. A contracting trade deficit would therefore lower the real GDP growth rate. The CBSLs statistical data illustrates this pattern of relationships.
7,000 6,000 5,000 USD MN 4,000 3,000 2,000 1,000
Positive relationship between real GDP growth and B.O.T deficit
10 8 6 4 2 0 -2
Trade deficit (USD MN) Source: Compiled according to CBSL statistics
GDP GROWTH%
As demonstrated in the graph, during 2001 real GDP growth rate dropped to negative levels and the balance of trade deficit also contracted in the same year; and since then the real GDP growth rate continued to gather momentum parallel to the gradually expanding trade deficit. In 2009 alongside a significant drop in balance of trade deficit the growth rate declined to 3.5 percent from 6.3 in 2008 and the economic activity significantly lost momentum; it however, rapidly picked-up to record 7.9 percent real GDP growth which went hand in hand with widening balance of trade deficit in 2010.
Balance of Trade Deficit and Government Finance

The structure of government tax revenue is an indicator of the specific investment spheres of the private sector from which government tax revenue is mostly derived. The tax revenue structure illustrates that a significantly large portion of consumer tax income comes from import-led activity. In 2009, approximately 80.9 percent of government consumer tax revenue (which accounts for nearly 80 percent of the governments total revenue) was derived through imports; and the latter figure during the last ten years has averaged 78.6 percent (see graph). The heavy dependency of government revenue on the import trade creates an
33
inverse link between the fiscal deficit and the balance of trade deficit of the economy. For instance, the escalating trade deficit in 2010 caused government revenue to increase significantly owing to the positive relationship which prevails between government revenue and the balance of trade deficit. Therefore, the tendency is, for the fiscal deficit to fall when the trade deficit expands.
500 400 LKR BN 300 200 100 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Imports based Consumer tax income (LKR bn) Non Import based consumer tax Imports based tax income as of Total Indirect tax income Source: Compiled according to CBSL statistics
Composition of indirect tax income
82 80 78 76 74 72
For instance in 2009, when trade deficit dropped to 7.3 percent of GDP from 14.7 percent of 2008, fiscal deficit increased to 9.8 percent of GDP from 7 percent of 2008. In 2010 trade deficit increased to 10.6 percent of GDP with imports surging and consequently fiscal deficit fell from 9.8 percent of GDP in 2009 to 7.34 percent during first eleven months of 2010. However, this inverse link operates only when import expenditure rises faster than export income; it is not so when an expanding trade deficit is triggered by a fall in export income.
16 14 12 10 8 6 4 2 0
The inverse movement of Trade deficit and Fiscal Deficit
%
70 60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010(f) Trade deficit as a % of GDP Government debt as a % of GDP Fiscal Deficit as a % of GDP Government debt as a % of GDP Source: Compiled according to CBSL statistics
34
In this connection, it is also important to note that when trade deficit expands government is less inclined to borrow domestically since as explained earlier, expansion of the deficit has a tendency to reduce fiscal deficit by increasing government revenue. Notice the inverse correlation between government domestic borrowings as a percentage of GDP and balance of trade deficit; during 2002 to 2008 the former gradually declined in relation to increasing trade deficit. And the two indices moved inversely during next two years. This tendency will also have a bearing on the excess liquidity levels of the financial sector of the economy. Considering these underlying trends we forecast the fiscal deficit to consolidate below 7 percent of the GDP in 2011 despite the fact that damage caused by recent floods will increase relief expenditure and domestic and external borrowings. The increased government expenditure will be supported by the rising balance of trade deficit expected to reach circa 12.6 percent of the GDP in 2011 from 10.6 percent in 2010driving up governments import based tax revenue.
The way Forward Sri Lanka

Industrialization marks the greatest divide in the contemporary world that of between the poor and the rich nations. The advanced world is linked to the underdeveloped regions by a peculiar division of economic activity: an industrially mature area on one hand, zones producing and largely exporting primary products on the other. The importance of industry above agriculture and services and the importance of specific types of industry above others should be explained in order to lay bear the dynamics of a nations economic development. Industrial progress is not merely an acceleration of GDP growth, but an acceleration of sustainable development, because of, and through, economic and social transformation. The qualitatively new ways of producing industrialization creates, unlike services and agriculture, bear the propensity of generating linkages to integrate the entire economic structure in to a single whole. Industrialization creates mutually interactive investments which has automatic continuity leading to a selfexpansion of the capital accumulation process. For instance, the technological methodology which was invented by the Americans to build fire arms with interchangeable units was borrowed to produce sewing machines and later, to build the automobile. The production of automobile automatically sprouted up dozens of more industries, an outcome creating a cluster effect in the economy leading to a selfexpansion of capital accumulation and generation of qualitatively superior employment. Such material expansion of the production structure is impossible to achieve by expanding production of neither primary goods such as garments and plantation crops or services. Such economic and scientific rationality and the progress of knowledge it brings forth is unattainable with investment patterns predominantly structured on import trade and servicing its deficits through remittances received mainly from housemaids. Increasing the number of housemaids employed abroad appears to be carrying the highest degree of comparative advantage relative to Sri Lankas other primary exports, as
35
foreign remittances do not incur a production cost and hence no outflow of foreign exchange. Though such form of FOREX inflows can phase-out balance of payments issues, feed the growing corporate profits and increase GNP, interpretation of it as economic development can be termed imprudent. Development and non-development is determined by the structure of products a country invests in. The level of economic development is not determined by expansion of services which increase luxury resorts, imports, property & real estate or supercentres. These are once for all investments not leading to further investments and nor any automatic continuity as mentioned earlier. The private sector of Sri Lanka has initiated extensive capital investments but not necessarily in economic spheres which lead to economic development. Wasteful or unproductive activity can generate profits and increase growth rate without realizing economic development. Hence, the use of growth rate as a parameter determining quality of growth or economic development of a nation remains questionable. It should be noted that prevailing investments structure is incurring wastage of FOREX gains of remittances and exports by siphoning the latter to meet the prospects of merchant and financial interests instead of manufacture. Hence, the rational in seeking Direct Foreign Investment for economic development is questionable when even the existing domestic resources comprised of current FOREX earnings and the large net earnings of conglomerates are unproductively utilized and huge portion of local capital is unemployed. The development of the economy therefore necessarily implies, in the present circumstance, the contraction of some bloated areas of the urban economy and diversion of these resources to the productive spectrum. Sri Lanka requires a substitution of its economic structure currently built upon investments concentrated around services and primary goods exports, to a structure derived from, and primarily basing itself on, technologically progressive industrial operations. In contrast to Sri Lanka, the pursuit of private profit in newly industrialized countries (NICs) like Singapore, South Korea, Malaysia, China, Taiwan and Hong Kong, led to a perpetual technological revolution in the production process and social transformation; while the entrepreneur choices of Sri Lanka appears to be sustaining the preindustrial character of the economy. The manufacturing sector of Singapore is composed of industries with high levels of technological sophistication such as automobile, electrical appliances, computer hardware, textile and heavy machinery. The economic development of these nations can be attributed to the specific entrepreneur choices of their investing community which brought about a radical transformation of production functions. It is often assumed that an economy of private enterprise has an automatic bias towards innovation, but the investment patterns of Sri Lankas entrepreneur economy has not yet reflected similar outcomes.
36
Export composition of Sri Lanka

17% Tea 30% 2% 2% 4% 1% 3% Minor Agri Products Gems Petroleum products Garments 41% Source: CBSL Other Industrial exports Rubber Coconut
The popular as well as more professional view of the economy is underscored by a sense of belief that free and uninterrupted functioning of market forces will automatically place the economy on a path of development now that the war is over. But the intrinsic functioning of the economy suggests quite the contrary. The economy will not shed its backwardness merely owing to the ending of war. The relatively high growth rate of the country deserves admiration; however, it demonstrates the specific pace of expansion of backward operations. The investing community, regarded as the engine of growth, therefore holds the task of bringing about a transformation in investment structure by developing a progressive relationship between the economy and itself. Hence, conscious and collective effort is required to restructure the investment of resources (labour and capital) for the development of modern industry.
37
Stock Market Outlook Sri Lanka
38
2010 In Retrospective
Key Events that had a bearing on the market
The forward march from a stunning year 2009 persisted as the Colombo bourse continued it climb up during 2010 to record a YTD return of 96.0 percent. After being recognized as the second best performing market by Reuters in 2009, CSE sustained the momentum to touch 7,000
39
levels in October 2010 and overtook Mongolia to emerge as the top performer in the world for 2010. However, CSE performance lost grounds thereafter shedding above 500 basis points till December. The more liquid Milanka Price Index (MPI) also gained in line with the broader market index by 83 percent during 2010 and surpassed its 7,000 milestone in September 2010. Despite the dip in the CSE since October 2010, MPI regained its 7,000 levels with the revival that was seen in the bourse over the past couple of weeks. Turnover levels were concurrent with the market performance taking the YTD average daily turnover to LKR2.4 bn.
The YTD foreign interest recorded a net outflow of LKR 32.6 bn. Having overcome few of the bottlenecks for investment in Sri Lanka; inclusive of political instability monetary and fiscal disciplines last year, we believe foreigners would revert their attention to Sri Lankas equity market.
40
2010 New Listings

Entities continue to show interest for listing especially from the finance sector due to regulatory obligations. All the Initial Public Offers (IPOs) during 2010, were over-subscribed reflecting the positive investor appetite. Company (Offer for Subscription)
Renuka Agri Foods Ceylon Tea Brokers Raigam Wayamba Salterns Vallibel Finance Odel PC House Hydro Power Free Lanka Laugfs Gas voting non voting *Pan Asian Power *Singer Finance HVA
No of Shares Offered
120,000,000 14,000,000 80,000,000
Issue Price (LKR)

2.25 2.00 2.50
Date of Issue
No. of Times oversubscribed

12.07 10.52 19.71
Date Listed
4-Jan-10 16-Mar-10 29-Apr-10
Value of the Issue (LKR mn)

270 28 200
27-Nov-09 16-Feb-10 29-Mar-10
5,200,000 16,700,000 57,233,300 35,000,000 75,000,000 52,000,000 200,000,000 26,670,000 19,900,000
22.00 15.00 11.00 10.00 23.00 15.00 3.00 15.00 16.00
31-Mar-10 5-Jul-10 5-Aug-10 26-Oct-10 4-Nov-10 4-Nov-10 7-Dec-10 15-Dec-10 11-Jan-11
9.12 63.90 4.26 57.05 16.45 17.90 7.00 120.00 24
4-May-10 4-Aug-10 26-Aug-10 25-Nov-10 8-Dec-10 9-Dec-10 7-Jan-11 17-Jan-11
114.4 250.5 629.53 350 1725 780 613.1 400.05
15-Feb-11 318.4 *Initiated trading in January 2011
New Listings 2010 by Sector

Sector No of Issues No of Shares Indexed Value (Rs.)
Banks Finance & Insurance Beverage Food & Tobacco Services Information Technology Footwear & Textiles Power & Energy
3 2 1 1 1 2
66,756,241 683,457,320 114,000,000 228,933,334 144,950,000 496,088,198
114,400,000 470,000,000 28,000,000 629,566,300 250,500,000 2,855,000,000
Total
10
1,734,185,093
4,347,466,300
41
Source : Colombo Stock Exchange
Sector performance 2010 at a glance
YTD % change in Indices

Telecom Stores Supplies Power & Energy Motors land & Property Investment Trust Hotels & Travels Diversified Construction & engineering Bank Finance & Insurance ASI
-100%
0%
100%
200%
300%
400%
500%
% Change In Indices
42
Banks, finance and insurance, one of the heavy weight sectors, exhibited strong performance in terms of earnings during the year, majorly due to accelerated economic activities in the country. The same momentum can be expected going forward which would be backed by significant investment in branch expansion and investor friendly policies imposed by the government. The major contributors to this growth are Hatton National Bank, Commercial Bank & LOLC. The Hotel & Travels sector saw a great revival during the latter part of 2010 as many hotels plunged into operations after their refurbishments in mid 2009. Colombo city hotels such as Galadari, Cinnamon Lakeside and Cinnamon Grand highly benefited with the corporate activity level grabbing in many foreign visitors. Resort hotels were also able to improve their bottom line with the seasonal foreign tourist arrivals. Going ahead, with Sri Lanka having already catered to 654,476 tourists during year 2010, is targeting 2.5 mn tourists by 2016. The hotel and the leisure sector as a whole will be a direct beneficiary of these expectations. The food & beverage, one of the key sectors listed in CSE, posted positive earnings during the year. Poultry sector players (Bairaha Farms and Three Acre Farms) sustained their growth story benefiting from the increased chicken consumption in the country. Cargills (Ceylon) also contributed to the sector growth with the addition of the North and East markets to its customer base whilst momentum continued in liquor oriented businesses (Distilleries, Lion Brewery and Ceylon Brewery). The sector would sustain its growth as most of the counters that contributed to the sectors performance to continue to capitalize on the post war scenario. However, certain counters such the Distilleries, Lion Brewery and Ceylon Brewery; despite increase in their top line the sector would find their net earnings being squeezed with the increment of corporate taxes to 40 percent from 35 percent and the upward revision in the excise duty structure. Throughout the past, earnings of the Manufacturing sector had been highly volatile, which was mainly due to seasonal impacts and unfavorable macroeconomic outcomes in the global economy. Chevron Lubricants, Royal Ceramics and Tokyo Cement further strengthened the sector earnings during 2010. Though the telecommunication sector includes only 2 counters, it contributed approximately 5 percent to the total market. The sector witnessed healthy earnings posted by two participants during the year. Going forward the sector has potential in the local context with the technological advances together with the high penetration levels in the island. Further with government reducing the call charges we expect the revenue to grow due to the high elasticity of the product coupled with the growing per capita income. The Diversified sector earnings approximately doubled during the year. The earnings growth was shouldered by the heavy weight John Keells Holdings with its capital gains through Asian Hotels & Property and Keells
43
Hotels. Even though the sector earnings show high fluctuations on QoQ basis the earnings has usually outperformed the sector and the market. Going forwards we expect the diversified sector to report higher earnings on the back of the high geared local economy. Further the sector would benefit with the low interest rates persistent in the island together with the high investment rate as the sector is prone to diversification. During June 2010 government reduced import duty for vehicles by 50 percent. This has immensely helped the stagnant industry to move ahead. With the new budget proposals government has reduced import tax on heavy vehicles. This would positively impact on the earnings of counters like Lanka Ashok Leyland, Dimo, Sathosa Motors and United Motors during the upcoming quarter. Construction & Engineering sector perform relatively well comparison to the market during 2010. This was mainly backed by increasing income generated through post war developments and increasing demand for land & property in Colombo city limits. The growth was further facilitated by reduction in income tax for construction companies and reduction in custom duties for raw materials and capital equipments.
44
Manufacturing
Sri Lankan stocks surged at a staggering rate since mid 2009 ending the year edging up 86 percent and continuing its upside trend at 82 percent by the end of 2010. Since then the country witnessed significant developments taking place along with the turnaround in the global economy. From a Sri Lanka context, developments across the countrys three economic sectors, i.e. the Industry, Agriculture and Services, was clearly visible, where the countrys infrastructure developments took a prominent role, which in turn benefited the manufacturing sector.
Source CSE Data Library
The manufacturing sector approximates to 6 percent of the total market capitalization of the Colombo Stock Exchange, with an array of reputed entities catering mostly to the Construction, Food & beverage and the Automobile segments. Chevron Lubricants (LLUB), with its 120mn shares in issue, captures nearly 13 percent of the sectors market capitalization, followed by Royal Ceramics (RCL), Voting shares of Tokyo Cement (TKYO), Ceylon Grain Elevators and the countrys sole flacconage manufacture, Piramal Glass. Total sector earnings, averages to LKR 7.9bn (USD 71mn), where the top five index heavy weights, accounts to circa 64 percent of the earnings. The sector PER is around 17.1x, which is relatively in line with the total market PER 18.5x, where on the other hand its Price to Book Value (PBV) is 3.1x while the market is at a PBV of 3.0x, reflecting the manufacturing sector to be underrated.
5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0
Manifacturing Sector performance VS the ASI
8000 7000 6000 5000 4000 3000 2000 1000 0
MFG Index
ASI
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The historic earnings in this sector has been solid, even during a gloomy macro environment in the country, especially the index heavy weights have continued to post positive bottom line although the growth has been on a slow pace. However we believe with this upturn in the in the local economy, with the GDP targeted 7.5 percent will continue going forward. Further adding weight on the countries ongoing development projects taking place, as well as the proposed large scale infrastructure projects, expected to initiate would bring in a definite upside potential towards counters such as the Royal Ceramics, Lanka Waltile, Tokyo Cement etc that has a considerable weight on the indexes. Hence, we anticipate a growth of 12 percent YoY for the year 2011, and moving higher 22 percent growth for the year 2012. Based on 52 week analysis, the Manufacturing sector has edged up 88.4 percent, when the benchmark, All share index has edged nearly 95 percent. This indirectly highlights that the sector still has potential to grow. In addition, based on the expected future earnings, it further justifies the sectors ability to move forward from its current levels.
Plantations
Plantation Industry underwent a period of revival during year 2010, with most of the plantation companies witnessing thumping growth in their earnings. Growths are backed mainly by escalating commodity prices, due to global economic recovery, and the increased production with comparatively supportive weather conditions. Rubber The world rubber industry went through a highly volatile period with the global economic recession that prevailed during the past few years. The drastic dip in crude oil prices that resulted from global economic recession, lead the synthetic rubber (SR) prices to fall down to significantly lower levels (SR is manufactured using crude oil which is a substitute for natural rubber).
46
Consequently most rubber based manufacturing industries started to prefer cheaper substitute synthetic rubber over natural rubber (NR), which pushed the NR prices, decline to very low levels. Subsequently with the global economic recovery, crude oil prices started to move up (current price of crude oil is at $100.7 per barrel) which led Sri Lankan rubber prices to increase from a lower of circa LKR111 per kg (RSS1) in December 2008 to an all time high level of circa LKR624 (RSS1) in February 2011). Furthermore, according to world rubber magazine, the global NR production is expected to fall behind its consumption up to 2020. Currently there is a supply deficit of 446,000MT in the rubber market which is triggered primarily by the fact that leading natural rubber supply nations in Eastern Asia (Malaysia, Taiwan) switching to high yield oil palm cultivations coupled with the adverse weather conditions in India and other main suppliers. Sri Lanka is the 6 largest exporter and 8 largest natural rubber producing country in the world and Sri Lankas rubber industry constitutes 0.3 percent of countrys Nominal GDP. For FY2010, country recorded a rubber production of 150mn kg, which reflected a growth of circa 9.5 percent YoY. We expect the production growth to be further supported by the successful replanting of the plantation companies. The net sales average (NSA) recorded for the year was outstanding at LKR402.7 per kg, which is an almost 100 percent growth YoY. Tea During FY2010, tea production in Sri Lanka was affected marginally by weather, though it yet showed an increase over FY2009 to record 329mn kg (13.5 percent YoY growth). Sri Lanka tea fetched higher prices in FY2010 over FY2009 (throughout the period) and recorded the highest across the world which lead the country to record an all time high overall NSA of LKR370 per kg. Tea exports in Sri Lanka increased by 11.2 percent YoY to reach 311.0mn kg during the FY2010, whilst rupee earnings from tea exports recorded its highest ever at LKR152.1bn. FY2010, began with a deficit in global tea supply, is currently experiencing a surplus in production with the significant 10.2 percent YoY growth in crop witnessed during the year. Hence aggressive promotion is becoming inevitable for the tea producing nations to secure attractive prices for their tea production. Therefore the initiative taken by Sri Lankan government to promote value added tea, over bulk tea exports (budget 2010 includes a provision to increase CESS on bulk tea export to LKR10 per kg combined with the newly taken measure to implement a
th th
47
major promotional campaign to market Ceylon tea brand across the globe) would enable Ceylon tea industry to remain competitive in the long term.
Oil Palm Oil Palm could be considered as the sunrise industry in the south Asian region, where many growers in the region seen moving aggressively towards the crop in the light of highly attractive returns. Although Palm Oil is still mostly used in the manufacture of food products, its Potential demand as a bio fuel or biomass energy is significantly large, that signifies a potential to drastically increase the demand for the crop. The increasing trend in petroleum prices with global economic recovery has stimulated the bio fuel industry in European Union, United States and as well in Malaysia to some extent. From a Sri Lankan context, Palm Oil is a commodity having a huge growth potential, where only 5 out of 22 regional plantation companies are currently serving this segment. Sri Lanka produced 54.3 mn kg of fresh fruit during year 2009, which reflects a growth of 3.2 percent YoY. Recently Sri Lankan Government has taken some important steps to spread palm oil cultivation in the country, identifying its huge potential as a highly profitable commercial crop. Accordingly, the Government aims to achieve a fivefold growth in area cultivated to reach 50,000 acres in the near future. Sector Performance from a stock market perspective There are 17 Plantation companies listed in Colombo Stock Exchange, which in combination add up to 2% of total market capitalization. Sector, albeit been subject to high fluctuations over the years, has notably outperformed ASI on a continuous basis. Sector generated a cumulative net profit of 4.5bn for the 4 quarters ended December 2010. The largest contributor in terms of profits was Kegalle Plantations (KGAL.N.LKR199.40), which added up to 17.9% of sector earnings. We expect KGALs contribution to enhance further with soaring rubber prices placing company at a definite advantage, as the largest rubber producer out of 22 regional plantation companies. KGAL posted a net profit of LKR567.6mn for the 1-3QFY11, reflecting a massive 342% growth YoY. .
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Plantation setor performance VS The ASI

300 250
Index
200 150 100 50 0
PLT ASI
Kotagala Plantations in line with KGAL, contributed to 13.8% of sector earnings. KOTA, one of the largest Plantation companies listed, produces the largest cumulative volume of tea & rubber. Malwatte Valley Plantations, Namunukula Plantations, Watawala Plantations and Kelani Valley Plantations became the next largest profit producers adding 11%, 9%, 8% and 7% respectively to sector earnings.
Plantation sector production composition

ELPL UDPL NAMU MAL KOTA KGAL HOPL BOPL AGAL 0 5000 10000 15000 20000 25000 Tea Rubber Oil Palm Coconut
Looking ahead, Global demand for tea is expected to grow with the increased consumption due to recovery of global recession, as
49
well with the emerging trend ( particularly in European Union ) to switch from other beverages to tea, due to scientifically proven positive health impacts of tea. However, Plantation companies serving prominently to tea segment will have a concern with plantation worker wage revision is due in April 2011(Plantation worker wages are reviewed every 2 years according to an agreement between trade unions and government). Labour constitute up to circa 55percent of tea cost of production. According to world rubber magazine, the global NR production is expected to fall behind its consumption up to 2020. Meanwhile with the current tight market conditions for rubber, rubber supply is not growing at the expected pace due to older plantations and due to weather constraints whereas demand conditions are continuously improving with global economic recovery, we can expect rubber to trade at current high levels. Considering Palm oil industry, it has been growing at an impressive rate of circa 9 percent for last few years and the demand is expected to improve further with increased global economic conditions, shouldered with impact from increased population and as well due to increasing demand for alternative energy sources. Furthermore, plantation sector counters which have a significant exposure to rubber, Oil Palm will be less susceptible to upcoming wage revision of plantation workers (due in April 2011), where both the crops generate attractive margins and are less labour intensive compared to tea. Meanwhile, Companies catering heavily to low grown type of tea would also be at an advantage, with low grown trading at premium prices over other tea categories. Against this backdrop, we expect Plantation Sector earnings to grow at 11 percent YoY in FY11E and by 12 percent YoY in FY12E.
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Banking and Finance

Banking system is considered to be the back bone for the economy, where a strong financial sector is a prerequisite for economic developments in post war Sri Lanka. With higher expectations of economic developments, the sector is expected to grow leaps and bounds. There exist a strong correlation between the GDP and the sector performance. As a consequence the banking and finance sector will grow, on back of GDP growth and favorable regulatory frame work.
Licensed Commercial banks (LCB) Commercial banks in Sri Lanka provide banking facilities to individuals and business entities. As per the Central Bank annual report 2009 there were 22 commercial banks in the country, with a network of 2,214 branches. Commercial banks are further categorized as public sector banks, private sector banks and foreign banks.
Performance of Licensed Commercial banks (LCBs)
9 months revenue (LKR mn)
45 40 35 30 25 20 15 10 5 -
700 600 500 400 300 200 100 -
* Based on revenue & total Total assets Revenue for 9 months

assets as at 30/09/2010
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Total assets (LKR mn)
As at end of 2009, total assets of LCBs stood at LKR2.5 trillion, an increase of 10.8 percent, compared with a 7.7 percent previous year. In addition the 2 state owned commercial banks, Bank of Ceylon and Peoples bank account for a circa 50 percent of the sector asset base. The sector is getting more attractive with recent changes in regulatory measures. The corporate tax rate has reduced from 35 percent to 28 percent where as VAT on financial services has reduced from 20 percent to 12 percent. In addition the new low interest rate regime emphasized by the Central Bank would drive the loan growth in the sector. Consequently, as oppose to lower rates being paid on deposits, more funds would flow in to the system, as a result of previously war affected areas getting banked. Further, the Central Bank is focusing on raising a mandatory deposit insurance scheme. The purpose of the scheme is to grow up a fund which can be utilized to compensate depositors in a crisis situation that can arise by the particular institution being suspended or cancelled by the monitory board. This new regulation would cement the investor confidence towards banks resulting in more deposits to flow to the system.
Insurance
Currently 19 registered insurance companies operate in Sri Lankan insurance industry. 12 of them are composite companies which deals with both general and long term insurance, 5 companies engaged in general insurance and 2 companies engaged only in long term insurance. The total Gross Written Premium of the industry was LKR 57.25 million in 2009 of which more than 50 percent is contributed by two dominant players. The total assets of all insurance companies at the end of the first six months of 2010 exceed LKR196.6 billion, up by 9 percent compared to previous year end. Gross Written Premium for the six months was increased by circa 11 percent to LKR31.3 billion compared to that of previous year. Government re-entering the industry with the acquisition of Sri Lanka Insurance and competing aggressively in the market has change the competitiveness in the industry notably.
Life Insurance Insurance companies have issued 464,249 new life insurance policies during the year 2009 which is 16.5 percent decline against previous year new issues. The total number of life insurance policies in force at the end of 2009 was 2.1 million and the penetration of the life insurance business as a percentage of the total population was circa 10.4 percent. The overall Gross Written Premium Income of Long Term Insurance Business amounted to LKR 13.12 billion (2009 - LKR 11.31 billion) during the first six months of 2010.
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9,000 8,000 7,000 GWP LKR mn 6,000

CIPLC 32%
Market share - Life Insurance

SUCL CIPLC UAPLC ANDBIPLC
ANDBIPLC
5,000 4,000 3,000 2,000 1,000 0 2

UAPLC 11% SLICL, 20%
JIPLC COICL AAIPLC
19%
JIPLC 5% AAIPLC 4% HNBAPLC 4% LICLL 1%
HNBAPLC ATPLC LICLL
COICL
* Companies with atleast 1% market share
1%
ATPLC 1%
10
12
Asia is seen as an attractive market for global investors and private equity market. While much of the rest of the world saw a dip in insurance premiums, many of Asias emerging markets saw insurance premiums increase last year. Total revenue from life insurance premiums in Asia was US$989.4 million in 2009, up 2.8 percent from 2008, representing a 24.3 percent share of the worlds market. Insurance penetration rate in Sri Lanka is growing rapidly as compared to overall Asian region. The growing market density and penetration rate is due to high insurance awareness among consumers in urban areas. In fourth coming years, with the increase of per capita income and opening of fresh opportunities in North and East, the market is expected to further grow in to more rural areas.
Market share - General Insurance

12000 10000
CIPLC 27.12% SLICL 26.17%
SLICL CIPLC UAPLC ANDBPLC JIPLC
GWP (LKR mn)
8000 6000 4000 2000 0

ANDBPLC 7.48% COICL 1.78% UAPLC 9.59% JIPLC 12.76%
COICL AAIPLC CIL HNBAPLC ATPLC AILL
3 * Companies1 atleast 1% market share with
11
13
53
General insurance During the first half of the year 2010 overall Gross Written Premium Income of General Insurance Business amounted to LKR18.18 billion which is 8 percent increase from 16.88 billion incomes posted in 2009. The industry is expected to be further benefited by reduction in premium pertaining to terrorism cover by 75 percent and removal of War Risk Level applicable to Sri Lanka in the "Country Risks Evaluation and Assessment Model" (CREAM) performed by Joint Cargo Committee (JCC) London.
Leasing
At the end of the year 2010 leasing industry was driven by 74 financial establishments. Out of the total 19 were licensed commercial banks, 34 Registered Financial Companies and 21 Specialized Leasing Companies. The majority of the leasing companies have reduced their interest rates drastically with the positive reduction of policy rates by the government. This has created a serve competition among existing players in the industry. With the economic stability of the country and opening of the fresh untapped market in Northern and the Eastern provinces the growth momentum of the industry is expected to continue. Further, Leasing industry has a great potential for growth as leasing is seen as a easily accessible financing method for assisting Small & Medium Entrepreneurs (SMEs). With the government policy on encouraging investments in under developed areas may create more opportunities in the SME sector in the whole country. This has triggered leasing companies to expand its coverage across North & East and other rural areas. Government has granted capital allowances on equipment for leasing companies as a budgetary concession for the industry. The grant will be effective from April 1 this year enabling the leasing companies to lease not only vehicles but also equipment. As the industry revenue is mainly contributed by vehicle leasing, recent reduction in import duties on vehicles is expected to boost the industry to greater heights. The aforesaid stocks are the major contributors to the overall banking sector and the sector is expected to prosper on back of enhancing economic developments in the country whilst major banking counters taking their lead.
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Food & Beverages

The food and beverages sector plays a vital role in the expanding Sri Lankan economy and it contributes around 10 percent to the GDP of the country. In the context of Colombo Stock exchange, currently there are 20 companies listed under the beverages food & tobacco sector and these companies contribute around 13 percent to the total market capitalization which amounts to LKR 321 mn. Ceylon Tobacco spearheads the sector in terms of market capitalization and sector earnings and it is followed by Cargills Ceylon ltd, Distilleries, Nestle, Lion Brewery, Ceylon tea Services and few other counters. Of the 20 counters listed in the food and beverages sector, nine of the leading counters accounts for more than above 84 percent of the total market capitalization, whilst 92 percent of the sector earnings derived from these companies.
Taking into consideration the sector performance during FY10, it has improved 17 percent YoY, continuing the similar trend we expect the earnings to improve by 21 percent during FY11 and 20 percent in FY12 respectively. Ceylon tobacco being the largest contributor to the sector in terms of earnings would experience a marginal reduction mainly due to high exercise duties and tax rates imposed by the government and it would be further affected by improving resistance from the government towards smoking. The alcohol industry was already affected by the recent upward revision in excise duties, and the increase in taxation on profits to 40 percent from 35 percent. Counters such as Lion Brewery, Ceylon brewery and Distilleries, will find their Net Profit margins squeezing. Sri Lanka experienced a significant improvement in foreign influx during 2010, which was an increase of 46.1 percent against 2009. This upward momentum in tourist arrivals was positive on the food and beverages
55
sector across the board. Meanwhile this sector is further expected with an upside potential with the developments taking place in the untapped areas in the north and east of Sri Lanka. Major milk producing countries were adversely affected by the bad weather conditions prevailed throughout the last couple of months and that has negatively impacted on milk prices in the world market. Companies like Lanka Milk Foods and Nestle will be adversely affected under these unfavorable conditions. Further, due to the Government intervention on price increments and increasing competition in the market will result in narrow profit margins. Counters, which are in the food and beverage sector such as Cargills, Bairaha Farms and Three acre Farms, are highly exposed to seasonal variations also witnessed an upside potential alongside the recent foreign influx . Further, with the Economic recovery in the European and the Middle East it has led to an increase in the world tea prices .This has positively impacted on the counters like Ceylon Tea Services, witnessed growth in their top lines. As we expected the same upward momentum to continue going forward with the increasing demand for tea in the European region as well as the emerging markets such as china. Throughout last year inflation rates remained at relatively low levels resulting in the central bank to cut down policy rates to single digit levels. With the increasing commodity prices due to supply shortages have led the inflation to rise, placing downside pressure on private consumption growth, which would negatively impact on the sector performance. Meanwhile considering the coconut prices in the domestic market, it has shot up during last couple of months, which would give competitive disadvantage for the companies like Renuka Agri Products (which exports desiccated coconut to European and US markets) in the world market.
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Land and Property

The Sri Lankan real estate and property sector sentiment which is greatly influenced by the cultural dimensions persistence in the island has changed over the years. The community which preferred wide open houses rather than sharing one huge building has shifted their paradigm of thinking with the commercial capital becoming overcrowded. However, the suburbs and the villages in the country are still at a standstill in terms of change. The real estate sector in Sri Lanka saw its peak during the cease fire in 2003 with the positive market sentiment which prevailed during that period. However with the recommencement of the war, the land and property sector saw a sluggish trend up until the recent past. The end of the 30 year war brought new hope for the industry thus in anticipation of high economic growth and a higher demand for land and property, the supply side dynamics overtook the demand in the market. With demand growing at a slower pace than anticipated, the land and property prices did not see the originally anticipated upward trend and did not reach the high levels expected. The residential property sector in Colombo was flushed with the bloom of many condominiums which was focused at the elite market segment of Sri Lanka together with the foreign buyers. Even with the high end facilities and the luxurious life style the demand was not met as expected due to the cultural ideology persistent within the Sri Lankan community and the majority of the demand for the condominiums which was driven by the foreign expatriates stifled due to the global financial crisis. The artificial land and property prices also hindered the potential market. Yet there seems to be a demand for gated communities and housing compounds, which have become a popular way of living among the upper middle class of Sri Lanka in the recent past. During the past decade the high interest rates which prevailed in the island had a significant impact on limiting the demand for the real estate industry. With the reduction in interest during the recent past the prime lending rates dropped from 20 percent to around 12percentpa. Rental yield averages around 5percent-6percent in the real estate sector while some firms such as CT Land and Overseas Realty reporting above average yields. The norm in the industry is that rental yield should be able to break even with the interest/mortgage cost, yet the Sri Lankan rental yield is below the prime lending rates. We could expect a rise in rental charges over the years to increase in a greater percentage than land value, whereby the rental yield would be in line with the prime lending rates as in developed real estate markets. The Colombo bourse houses over a dozen Land and Property counters but only few companies could be directly identified with the land and property industry whereas the other companies are either in the maintenance and ownership of one building or is involved in diverse investments.
57
The demand for land & property has increased with the significant investments in the construction and engineering sector. This has ultimately resulted in an increase in the earnings for the year. Cargo Boat spearheaded the sector earnings with a net profit of LKR169 mn generated through other incomes. Further, though few of the counters in the sector reported a dip in earnings YoY basis, the sector recorded a growth shouldered by the land and property heavy weights such as Overseas Realty and Property Developers. The sector which previously witnessed a peak in its PE based valuations had a drop in the earnings levels on the back of the improved profits. The PBV of the sector which was stagnant on a low base gained over the last quarter whilst the dividends yield remained flat. The sector earnings have grown parallel to the Land and Property Index with a slight discount on the sector index. Further we could see a high correlation with the ASI movement and the sector movement. With increasing demand for more housing apartments and office complexes in the Colombo city, it is expected that the sector would continue the same growth in the upcoming quarter. Further the healthy rental yields and the low interest rates would shoulder the growth in the sector.
LAND PROPERTY
200.0 180.0 160.0 140.0 120.0 100.0 80.0 60.0 40.0 20.0 0.0
Earnings Vs Market
1600 1400 1200 1000 800 600 400 200 0 -200 -400
Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11
Index
Land & Property Index
ASI Index
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Leisure Sector
On a global perspective the first decade of the 21st century was a decade of extraordinary tourism growth, but also of sever shocks such as the 9/11 terrorist attract and the global economic down pour. Currently, with the recovery underway from the global economic down turn and the European Financial crisis we witness the international tourist arrivals up by 7% in 2010 throughout the globe. This tourist uplift brings around ripple factors to the island nation of Sri Lanka. With the 3 decade war ending, the local economic discussions are centered around tourism, and its true that tourists are coming to the island paradise by their numbers. The occupancy rates in the country records high levels whilst the average room rates are hitting record heights and the lucrative industry is set to boom with the immense groundwork set by the government. TOURIST ARRIVALS
80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0
Sri Lanka which surpassed its 2010 tourist arrival target by surpassing over 600,000 tourist arrivals to the country has focused on raising the countrys benchmark by setting a target of 700,000 in 2011 whilst having a target arrival rate of 2.5mn in 2016. However to achieve the high standards set by the governing bodies would require a 26% growth per month whereas the country only recorded a 14.8% growth for the month of February which was mainly on the back of the tourist influx by the cricket world cup. Further, the statistics show that the growth has been spearheaded by the 31,092 tourist coming in from the Western Europe with South Asia following its course with 13,585 tourists. As individual countries however, India managed to stand its place for yet another month with 10,071 tourists while UK hauled in as the 2nd largest with 9,614. Sri Lanka which witness the highest level of occupancy usually during December surged its room occupancy levels over 90% for December 2010. In the previous year (2009) this figure was statured at a low rate of 71.2% whilst the 5 stars recorded a marginal higher figure of 77% whereas in 2010 the top cluster of hotels witnessed an occupancy rate of 94.8%. This occupancy level
2009
59
in December 2010 was derived by a total room utilization of 14,714 across all star class categories. The tourist board of Sri Lanka is currently involved in few tourism infrastructure projects to uplift the range of offerings together with a unique experience to the traveler. The Kalpitiya project where the development of islands and a buildup of a casino complex is proposed along the dutch bay is currently under progression. Further, Eastern region development project rolled out by the SLTDA has set in place a process to fast track the development of Passikudah, Arugambay, Trincomalee, Nilavali and kalkudah within a set time frame. With investment rising in the said sector together with the many organizations and international brands such as Six Senses and Shangrila seeking to exploit the emerging market potential the leisure industry has witnessed a significant up lift. The government specifying a floor on room rates and having a lenient approach on foreign arrivals has also added value to the fast growing sector.
120,000 100,000 80,000 60,000 40,000 20,000 0 U.S.A. France Netherlands U.K. Germany Russia China(P.R.) Malaysia Singapore India Australia
TOURIST ARRIVALS BY DESTINATION
2009
2010
The total earnings from tourism for the period Jan-Nov 2010 amounted to USD 501.5 mn achieving a y-o-y growth of 64.3 percent. The average tourist spending per person at the end of the first 11 months of 2010 was USD 880 while the figure for the same period of 2009 amounted to USD 780 indicating a gradual shift to a higher market segment. Furthermore there is significant improvement in room occupancy rates of the higher star category hotels (72 percent in October 2011), both indicators of an emerging high end market segment. The sector witnessed a rapid escalation in the Colombo Bourse in expectation of the peace dividend and expectations of becoming the next tourist hub in the Asian region. yet over the past few months the tourism has statured to be in par with the high price levels. Looking forward with many counters expanding its capacity and opening up new hotels the future of the segment is in-line for
60
high earnings backed by the high occupancy levels prevailing in the country. Further, we could expect the sector earnings multiples to reduce from its current high levels due to the heavy influx of tourist arrivals. The favourable macroeconomic fundamentals which prevailed in 2010 strengthened by the removal of travel advisory restrictions and the favourable international tourism ratings received have paved the way for a thriving tourism industry. Such positive developments would increase the number of arrivals to reach 700,000 by end of 2011, boosting the income generated by tourism as well as hotel occupancy rates. Moreover it would trickle in to other sectors such as agriculture and transportation creating linkages and reinforcing Sri Lankas economic growth. Even though the Hotel Sector Earnings Index shows high volatility since June 2007 the Hotel Sector Index which was in line with the market seems to be trading at a discount to the All Share Index currently.
HOTELS TRAVELS
200.0 150.0 100.0 50.0 0.0 Dec-07 Dec-08 Dec-09 Dec-10 Mar-08 Mar-09 Mar-10 Mar-11 Dec-11
Dividend Yield P/E Ratio PBV
Jun-10
Jun-07
Jun-08
Jun-09
Sep-07
Sep-08
Sep-09
Sep-10
Jun-11
Further, the sector witnessed a high PE growth since the war ended together with the positive sentiment in the industry. However, in the recent past with the counters recording improved earnings the PE witnessed a dip. The sector PBV and dividend yields have been stagnant over the years with a slight improvement in PBV during the last quarter. Going forward with the positive industry sentiment together with the government initiative the sector is proved to prosper. The expected increase in tourist arrivals and the investment influx would further strengthen the growth in the industry. Therefore we expect the sector earnings to grow in the foreseeable future.
Sep-11
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Research
.................................................................................................
Head of Research Saminda Weerasinghe (94-11)5320250 saminda@asiacapital.lk (94-11)5320252 (94-11)5320258 (94-11)5320251 (94-11)5320360 (94-11)5320253 (94-11)5320253 (94-11)5320253 Senior Analyst Amali Perera (94-11)5320256 amali@asiacapital.lk (94-11)5320254 (94-11)5320257 (94-11)5320257 Corporates Akeela Rasheed Nuwan De Silva Crishani Perera Minoli Mallwaarachchi Nirmala Samarawickrama Shehara Fernando Dilan Wijekoon Economy Umayangana Randeniya Dhanusha Pathirana Nuwan Pradeep
Sales
.................................................................................................
INSTITUTIONAL SALES
Sabri Marikar Niroshan Wijayakoon Niyaz Aboobucker Anura Hedigallage Chelaka Hapugoda Chaminda Mahanama Hiran Bibile (94-11) 5320224, 077 3576868 (94-11) 5320208, 0777 713645 (94-11) 5320213, 0777-727352 (94-11) 5320211, 0777 713663 (94-11-5320240, 0777 256740 (94-11) 5320223, 0777 556582 (94-11) 5320238, 0777 352032
RETAIL SALES
sabri@asiacapital.lk Shiyam Subaulla (94-11) 5320218, 0773502016 niroshan@asiacapital.lk Gagani Jayawardhana (94-11) 5320236, 0714084953 niyaz@asiacapital.lk Priyantha Hingurage (94-11) 5320217, 0773502015 anura@asiacapital.lk Neluka Rodrigo (94-11) 5320214, 07773662 chelaka@asiacapital.lk Subeeth Perera (94-11) 5320227, 0714042683 mahanama@asiacapital.lk hiran@asiacapital.lk shiyam@asiacapital.lk gagani@asiacapital.lk priyantha@asiacapital.lk neluka@asiacapital.lk subeeth@asiacapital.lk
BRANCHES
Kiribathgoda Kurunegala Matara Galle CSE Floor Negombo Asian Alliance Building, No.04, Sirimawo Bandaranayake Mw, Kadawatha. Asian Alliance Building, No.254, Colombo Rd, Kurunegala. Asian Alliance Building, No. 312,Galle Road Nupe, Matara. Capital Reach Building, 2nd Floor, No. 16A, Gamini Mw, Galle. CSE,01-04, World Trade Centre, Colombo 1. Asia Asset Finance, 171/1, Station Road, Negombo. Asiri Perera 011-5734773, 0773-692812 Asanka Samarakoon 037-5628844, 0773-690749 Sumeda Jayawardena 041-5677525, 0773-687307 Ruchira Silva 091-5629998, 0773-687027 Lasitha Wijewardena 091-5676766, 077-6681884 Thushara Adhikari 011-5735122, 0773-688202 Uthpala Karunatilake 031-5676881, 0773691685 asiri@asiacapital.lk asanka@asiacapital.lk sumeda@asiacapital.lk ruchira@asiacapital.lk lasitha@asiacapital.lk adhikari@asiacapital.lk uthpala@asiacapital.lk
SERVICE CENTRES Kandy Capital Reach Building, No.165, Katugodella Veediya, Kandy. Hambantota Hambanthota Chember of Commerce, Thangalle Road, Hambantota. 2nd Floor, T.K.S. Building, D.S. Senanayake Street, Ampara.
Ampara
Nilupul Hettiarachchi 081-5628500, 0773-691816 Radhika Hettiarachchi 081-5625577, 0777-810694 Gayan Sanjeewa 047-5679240, 0715-536309 Anusha Muthumali 047-5679241, 0772-351716 Shermin Ranasinghe 0772378352 Ravi de Mel Madushanka Rathnayaka 063-5679070 Sutharshan 021-5671800, 0772-395811 Nirmalan 021-5671801, 0778-449773
nilupul@asiacapital.lk radhika@asiacapital.lk sanjeewa@asiacapital.lk muthu@asiacapital.lk shermin@asiacapital.lk ravide@asiacapital.lk shanka@asiacapital.lk suthan@asiacapital.lk nirmal@asiacapital.lk
Jaffna
11-8, First Floor, Stanley Road, Jaffna
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62

Srilanka Country Report-2011

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Srilanka Country Report-2011

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ASIA WEALTH MANAGEMENT CO.

SRI LANKA-COUNTRY REPORT 2011

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Is Government Spending Unproductive? Analyst Statistics Nuwan Kumara

Investment Structure and Inflation

Trade balance and the BOP

Increasing foreign reserves and the exchange rate

Foreign Debt Factor

Employment Generation and Investment Structure

The way Forward Sri Lanka

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Stock Market Outlook Sri Lanka 2010 In Retrospective

Sector Performance from a stock market perspective

Banking and Finance

Performance of Licensed Commercial banks (LCBs)

Leasing Sector Prospects

Food & Beverages Land and Property Tourism

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%

Table 1 - Conflict Years and Pre-Conflict Economic Growth

A Precursor Food for Thought"

21 years prior to ethnic conflict

Source: Compiled according to CBSL statistics

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Table 2 - Conflict Years and Post-Conflict Economic Growth

two years of intense war

post conflict period

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Gross Domestic Product (GDP)

SECTOR CONTRIBUTION TO GDP 2010

Country Comparison of the Nominal GDP (USD BN) 2010 Est.

South Korea, 986.3

Nepal, 15.11 Maldives, 1.433

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

10.0 8.0 6.0

Aggregate Demand and GDP Growth

Aggregate Consumption and Investment

RS BN 6000 5000 4000 3000 2000 1000 0

consumption (LKR bn)

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

160 140 120 100 80 60 40 20 0

Real wages Industry & Commerce Real wages Services

Real GDP growth

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Debt and its Composition

Commercial Bank Lending Portfolio

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Public debt levels as a % GDP

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Fiscal Deficit -% GDP (LHS)

Revenues/GDP (%) (RHS)

Is Government Spending Unproductive?

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Government debt mix as a % GDP

Government Expenditure as a % GDP

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Central Bank advances to the Government and Inflation

Asia Wealth Management CO. (PVT) LTD | Country Report 2011

Crude Oil prices vs Inflation

Crude oil price per barrel

Point to Point Inflation

Source: Compiled according to CBSL statistics

Asia Wealth Management CO. (PVT) LTD | Country Report 2011