Understanding the trade realities brought about by Sri Lanka's new administration

Sri Lanka is well situated for trade and an attractive target for international investment. Lying on major shipping and air routes, it is close to the markets of Asia, Africa and the Middle East. Moreover, the country has a literate workforce, good infrastructure, healthy population and relatively low wages.

Since the 2009 cessation of a long-running civil war, Sri Lanka has become one of the region’s more stable nations, and following elections in 2015, it has become more open and economically liberal. The new government has indicated it is doing away with the country’s statist past and is embarking on a period of material liberalisation.

A New Path

Historically, the country has found it difficult to attract international capital, diversify its export base and move to higher-value-added products. Trade deficits have occurred almost continuously since 1950, while foreign direct investment (FDI) has been too low to create the growth needed for the country to avoid the middle-income trap. Though the economy is generally open and underpinned by strong laws and a history of reform, Sri Lanka has been unable to address drances to doing business, with certain laws, regulations and policies standing in the way of greater investment and trade.

To hit the right targets in terms of FDI and exports, and ultimately in terms of economic growth, the country is likely going to have to make some fundamental changes that have so far been elusive, but are seen as increasingly possible under the new administration. Legal reforms, changes to land ownership rules and improvements to the business environment may be necessary if the government is to achieve its goal of 9% GDP growth.

Less Than Expected

From independence until the reforms of the late 1970s, FDI flows were very low. The numbers increased significantly from those reforms until 1983, when the start of the civil war between the military and Liberation Tigers of Tamil Eelam (LTTE) had the effect of scaring off capital. With the crushing of a Marxist insurrection led by Janatha Vimukthi Peramuna, known as the People’s Liberation Front, in the south in 1989, the introduction of fresh reforms in the 1990s, and the subsequent privatisation of state enterprises, FDI began to tick up again. However, these inflows of foreign investment slowed with the Asian financial crisis of 1997-98 and a rise in LTTE rebel activity.

Despite a commitment on the part of the government to address issues relating to investment in recent years, FDI has generally remained between 1% and 2% of GDP (the exceptions being 2009 and 2010). In dollar terms, FDI reached a peak in 2008, before dropping off and then surging again in 2011 to reach $981m, with it falling slightly to around $944m in 2014, according to the UN Conference on Trade and Development (UNCTAD). Figures from the Board of Investment of Sri Lanka (BOI) paint a slightly different picture. According to the BOI, FDI followed a similar pattern as reported by the UNCTAD up until 2011, but it reached $1.07bn that year and continued to grow, to $1.6bn in 2015 (see analysis).

Building Its Profile

The ups and downs of the investment environment have left a fair amount of room for Sri Lanka to grow its FDI portfolio. Just as Japan was starting to recycle its surpluses into Asia in the 1980s, the climate in Sri Lanka was worsening.

As a result, Sri Lanka missed out on the East Asian export boom and never quite got onto the roster for FDI from larger, wealthier Asian countries. “Sri Lanka attracts less FDI than expected despite its geographic, education and infrastructure advantages,” wrote the World Bank in early 2015.

The focus of FDI has changed over time and the exact targets of the country’s efforts remain a work in progress. Under the administration of Mahinda Rajapaksa, which ran from late 2005 to early 2015, the government prioritised relations with China over other historical investment and trade partners, such as those in the US and Europe.

As a result, total FDI numbers surged. However, the country is currently seeking to rebalance its economic relations due to concerns of overdependence, mounting debt and a high cost of financing. While China will remain an important partner going forward, the sources of investment are expected to be more varied under the new administration.

Import & Export Figures

Export earnings declined 5.6% in 2015 while import expenditures dropped 5% over the same period. The lower exports were to a great degree the result of lower tea production, prices and a ban on the import of seafood from Sri Lanka by the EU. From January 2015 till April 2016, the EU placed a ban on Sri Lankan seafood due to the country’s failure to sufficiently deal with illegal, unreported and unregulated fishing.

According to central bank statistics, tea exports increased since 1990 as the price of tea rose. But exports began to stagnate in 2015 due to weak global demand and instability in key export markets. In 2014, the country exported $1.63bn of tea; a year later, it exported $1.34bn. Overall exports have been following a similar trend and have stagnated. Exports as a percentage of GDP have been dropping rapidly. According to the World Bank that figure has fallen from 33% in 2000 to 15% in 2014.

Imports rose rapidly after the 2008 crisis and then stagnated as well, starting around 2011. As a percentage of GDP, imports of goods and services have been declining since 2011 from 34% to 26% of GDP in 2015. While oil imports fell significantly in 2015 – by 39.6% atop low prices – non-oil imports rose 9.9% largely driven by vehicle imports, which rose 53% over the course of the year.

Transition

The country did successfully shift from an agriculture export oriented economy more toward a manufacturing export oriented one, although the transition has not brought the benefits that were expected. Manufactured exports have been overly focused on garments, and developments elsewhere have been few and far between. Another problem is the high import content of Sri Lanka’s exports, which limits the benefits of manufacturing. Analysts also point out that the country needs to diversify its agricultural exports away from a dependence on tea.

According to provisional data from the Central Bank of Sri Lanka (CBSL), in 2015 around 46% of exports were from the textiles and garments sector, followed by tea with 13% and rubber with 7%. Spices comprised approximately 4%, while coconut products, gems, diamonds and jewellery, machinery and mechanical appliances, and food, beverages and tobacco all accounted for 3% of exports each. For its part seafood made up 2% of total exports.

Key Partners

According to UNCTAD, the biggest export destination for Sri Lankan products in 2014 was the EU, absorbing 31% of overseas sales, followed by the US with 24% and India with 6.5%. This was followed by the UAE (2.6%), Russia (2.4%) and Turkey (2.3%). In terms of imports, the leading country was India (at 20.7%), followed closely by China (17.7%) and the UAE (9.1%). China’s share was up significantly, rising from 5.1% in 2003. For 2014, the EU had an import share of 8.3% and the US 2.6%. The fastest-growing export segment in 2015 was spices, which grew by 42.6%; however, a number of core export categories saw downturns for the year. Garment exports, which made up 43.4% of the total, were down by 2.7%, while tea, which accounted for 12.8% of the 2015 total, saw a 17.7% decrease for the year.

In the garments segment, key export markets for 2015 included the US, receiving $2.1bn of exports, followed by the UK ($816.8m), Italy ($356.5m) and Germany ($197.2m). Meanwhile, for tea, Russia was the largest recipient of Sri Lanka’s output ($156.9m), followed by Turkey ($138.11m), Iran ($131.7m) and Iraq ($98.5m). Rubber was the third-most-important export in 2015, and key destinations included the US ($256m) and Germany ($84.6m). Other key export categories for 2015 included spices ($377.4m), petroleum products ($373.9m) and coconut ($351.7m),

Free Trade Agreements (FTAs)

There are a number of existing and pending preferential trade agreements in place (see analysis). Sri Lanka has signed FTAs with India and Pakistan, and the Ministry of Foreign Affairs (MFA) has expressed serious interest in signing an FTA with China, which would give duty free access to a market of 1.3bn people. China currently has some concessionary access to Sri Lanka, as well as a signed trade and investment framework. The MFA has also expressed interest in new agreements with Turkey and Singapore, which are being prioritised in 2016, as well as a willingness to join the Trans-Pacific Partnership, though no deadline or progress has been publicised.

There is significant scope to expand the relationship with India, though this in particular remains complex (see analysis). Trade agreements are largely spearheaded by the Ministry of Development Strategies and International Trade, inaugurated by the new government following parliamentary elections in late 2015. However, administratively much of the authority still sits within the Department of Commerce under the Ministry of Industry, which presents an administrative burden on effective policymaking.

Vulnerable

Sri Lanka is particularly exposed to trade restrictions. In 2010, GSP Plus (GSP+) privileges were revoked by the EU as a result of the failure to meet the requirements of the preferential trade programme. The EU acted in response to perceived shortcomings in Sri Lanka’s implementation of a number of UN human rights conventions. The new government has said that it will be applying to get GSP+ reinstated and would submit its application in 2016. Under GSP+ a total of more than 6000 products are eligible for export to the EU duty-free.

Between February 2015 and April 2016 the EU banned imported fish from Sri Lanka, largely around the issue of vessel monitoring systems (VMS). The EU accused the country’s fishing sector of switching off VMS while in international waters, although the issue was that deep-sea vessels (DSVs) had not actually installed VMS, as there was no legislation by the government of Sri Lanka to do so.

In April 2016 the EU lifted the 15-month fish ban after Sri Lanka changed its laws regarding illegal, unreported and unregulated fishing. A key EU requirement being that VMS must be installed on all DSVs (and their use monitored by the Sri Lankan authorities) before the ban could be lifted, among other minor demands. “Sri Lanka has now a robust legal and policy framework to fight illegal fishing activities”, said EU Fisheries commissioner Karmenu Vella in a press statement.

Prior to the ban, the EU accounted for nearly one third of Sri Lanka’s seafood exports, which decreased 35.5% in 2015 from 2014 numbers.

Previous Administration

While the former government, led by Rajapaksa, attracted a significant amount of foreign investment, its policies have been blamed for a range of problems faced by the country. Vital liberalisations were brought to a halt, key privatisations were stopped and government ownership of banking, transportation and utilities was promoted, according to the US State Department’s “Sri Lanka Investment Climate Statement 2015”.

While the administration sought to make the island nation a trading centre, especially for businesses seeking to tap into the Indian and Chinese markets, it also began to re-establish import-substitution strategies popular before the liberalisations of the 1970s and placed high taxes on key consumer items.

The US State Department commented that frequent intervention by the Sri Lankan government in the national economy was often a key challenge for international investors.

In 2011 a controversial nationalisation law was issued in order for the state to acquire underperforming businesses. A total of 37 such companies were targeted, and two key enterprises were taken over: the Sevanagala and Pelwatte sugar factories.

Privatised in 2002, they were nationalised and brought under the umbrella of the Lanka Sugar Company – which is managed by the Ministry of Plantation Industries – in 2012. While the companies were eventually lifted to profitability, the transition to government ownership was disruptive and expensive; the Treasury had to pay salaries as the factories were forced to shut down for a period.

The new administration is looking into the nationalisations, though at the time of writing in early 2016 it had made no commitment to returning the assets to their previous owners. Sources from the CBSL told the local press that what had been done was not actually nationalisation. They explained that the factories in question were on government land that had been provided to the companies.

Perhaps the biggest blow to FDI in recent years, or at least to FDI sentiment, was a change in the law on foreign ownership of land. In 2014, an outright ban was placed on non-Sri Lankans buying real estate.

A number of categories, including embassies, condominiums above the fourth floor and strategic development projects (SDPs), were exempt. Up to that point, foreigners could buy land by paying a 100% transfer tax, but the government at the time believed that too many companies were using structuring to avoid paying the required duty.

The new law limited foreigners to a 99-year lease and required them to pay a 15% tax on the full value of the lease up front. Analysts and domestic observers say that the ban itself is not necessarily a problem for foreign investors, as many countries have such prohibitions and investors are able to conduct business in those countries without a problem. The main issues, they noted, were the cost of the tax and the uncertainty that the change created. A sudden introduction of a new and fundamentally important policy sent a disturbing signal to investors.

“The foreign land ownership law scared people,” Jayani Ratnayake, economist at the Ceylon Chamber of Commerce, told OBG.

New Government

The new government has been welcomed almost universally in the West. It is committed to more open and transparent administration, reducing presidential powers, improving human rights and liberalising the economy. A wide range of reforms, policies, measures and promises have been mentioned in the early months of the new administration. While it is unclear how much will get done and how soon, the list of possibilities suggests a decisive break with past practices.

The CBSL has said that under the new government it is hoping to end remaining currency controls and undertake a number of major reforms in the financial markets. These include reforms to the land lease tax as well as the ban on foreign ownership which have been abolished. In addition to these, lower taxes and fewer tax bands were also in the budget for 2016.

Ambitions

On the trade side, the new government has committed to some noteworthy goals, specifically, for exports to equal 100% of GDP, $20bn of exports by 2020 and $50bn by 2050.

In order to meet these targets, the government is planning to create 45 “hyper-zones” in high-tech manufacturing, fishing, services, agriculture and tourism to allow the country to compete better internationally, according to PwC. Importantly, the government is also looking at an overhaul of the public sector and state-enterprise reform through a newly created Ministry of Public Enterprise Development, both of which are deemed necessary to keep the economy open and competitive.

Prime Minister Ranil Wickremesinghe has made a number of significant promises in his first few months in office. He announced that he would form a trade agency to handle all aspects of international trade and sign new trade agreements with various global partners, as was as an agency for development to help bolster the country’s one-stop shop for investors (see analysis). He has also made other pledges, including to remove impediments to investment, establish an information communications technology infrastructure that will help facilitate investment, and restructure the BOI, Export Development Board and Tourism Development Authority.

Wickremesinghe’s message in late 2015 was more one of transformation than of incremental steps. He promised to initiate a third generation of reforms (after those of JR Jayewardene in the 1970s and of Ranasinghe Premadasa in the 1980s), and sent a very clear message, according to local observers, that the fabian policies inherited from overseas must be cast aside. “Since the days of the Second World War, we have lived with a false notion that the government must somehow intervene in the economic process. This has resulted in many drawbacks, as we all know. The government took over many private enterprises at the time. Heavy taxes were imposed on the private sector that negatively affected imports and exports,” the prime minister told Parliament in late 2015.

Pragmatism Or New Order

Notwithstanding the positive outcome of the recent election, many investors and policymakers will need to take notice of the new government’s non-alignment.

Sri Lanka is likely to balance its interests between new and traditional partners. While the new government is examining the activities of the previous administration and seeking to end certain policies and practices, it is not necessarily seeking a reverse to the days prior to Rajapaksa.

At the same time, the country’s move toward a more balanced trade policy going forward should serve Sri Lanka’s long-term interests around increased investment flows from multiple entities.

More importantly, it is not yet clear exactly what type of government is being created. The United National Party is seen as pro-business and liberal, but it also has populist tendencies.

Economic Realities

Somewhere between the rhetoric of populism and that of economic transformation, clear policy is emerging, and it will likely be positive for the trade and investment situation. After years of focusing on infrastructure, Sri Lanka is now moving back towards the development of industry. Infrastructure will still be built, but not on the grand scale and at the rapid pace of before. In addition, it will most likely be undertaken in a more transparent and balanced manner. “In terms of what we are looking for, it is manufacturing,” Renuka Weerakone, executive director of investment promotion at the BOI, told OBG. “Earlier the focus was on infrastructure; now, it is on manufacturing. Infrastructure will happen in the future, but will be structured differently.” It is also becoming clear that the government is likely to rationalise the incentives available to investors (see analysis). The country has been offering tax incentives since the 1960s, during the import-substitution era, when it provided support for investments in tourism, export and pioneering industries.

As the country started to change its strategy to a more export-oriented focus, these incentives became a central theme of its economic policies. Over time, both the Inland Revenue Department and the BOI started offering incentives, leading to a duplication of efforts and an increase in total incentives given. The BOI was particularly prone to erring on the side of being generous, as its priority is investment rather than tax revenue.

The overall effectiveness of the incentives have been questioned, while it is widely acknowledged that the incentives have led to a thin tax base. “For now, there is a rationalisation of the granting of concessions,” Weerakone told OBG.

SDPs have already been targeted for cutbacks. In 2015, five of these projects not yet granted incentives were unlikely to receive the benefits. The most controversial of these projects is the Port City project, which is to be built on reclaimed land in front of Galle Face in Colombo, approximately 20 ha of which was to be freehold. Although there was initial uncertainty and delays, in January 2016 the prime minister announced that this project would indeed go ahead, albeit with some revisions.

Doing Business

The US State Department has noted that although the BOI offers a one-stop service for investors, the reality is far more complicated. In its Investment Climate Statement for Sri Lanka it said that the bureaucracy at times works at “cross purposes” with the BOI, especially when it comes to large projects outside of export-processing zones.

The department also cites other risks in the market, such as expropriation, contract repudiation and labour difficulties. It added that the reform of state-owned enterprises is likely to face resistance from trade unions. Moreover, despite optimism about the new administration, the State Department noted that trade and investment costs may be high in the country due to unpredictable policy going forward.

The BOI remains committed to improvements and believes that many of the problems can be easily resolved, and that they are administrative in nature and able to be addressed without having to get into legislative or constitutional confrontations. Even before significant reforms take place, much can be accomplished. A clear, simple tax schedule, and a set of reasonable incentives, would certainly help.

Improving the business environment would also make it much easier to attract international capital, and an international trade agency and an agency for development are currently in the planning stage. Sri Lanka was ranked 107th in the World Bank’s “Ease of Doing Business” report for 2016, up six places over its 2015 standing. The country saw strong improvement in some areas, specifically dealing with construction permits, moving up from 106th to 77th, as well as starting a business, in which Sri Lanka rose to 98th, up six places from a year previously. However, Sri Lanka continues to lag in some categories such as enforcing contracts (161st), paying taxes (158th) and registering property (153rd). In May 2015, the minister of finance, Ravi Karunanayake, told the press that one of the focuses of the new government would be the removal of red tape. One step taken by the Ministry of Finance (MoF) was to launch an ease of doing business web portal in late 2015 which can be accessed through the MoF website, as well as frequent localised ease of doing business forums. The tools allow businesses and entrepreneurs to submit queries to the relevant ministries.

Financial

Throughout all the political highs and lows, and various changes of government, financial investments have held up well. In 2014, the Colombo Stock Exchange (CSE) experienced record inflows in rupee terms (though not in dollar terms). According to CBSL statistics, a total of LKR21.7bn ($156.2m) entered the market that year from overseas. This followed inflows of LKR33.9bn ($244.1m) in 2013 and $267.81m in 2012. In the three years previous, the market experienced outflows of $171.51m in 2011, $222.41m in 2010 and $6.54m in 2009. Atop international financial conditions and investor sentiment, 2015 was a challenging year with net outflows reaching LKR4.4bn ($31.7m), though performance was not nearly as troubled as that of many regional peers. Sri Lanka has recently become popular with the international investment community.

With good infrastructure in place, a strong reform story and a stock market having performed well in the past few years, the country has started to get the attention of foreign capital. The CSE All Share Index more than tripled from early 2009 through the end of 2010, and reached a record high in 2011. It then fell through early 2012 before rising again on renewed foreign interest.

The appetite for the country’s sovereign debt is strong as well. In October 2015, Sri Lanka sold $1.5bn of 10-year bonds at 6.85% despite indicative pricing of 7% (see Capital Markets chapter). Moreover, in May 2015, the country sold $650m of 10-year bonds at 6.125%. Meanwhile, the number of cross-border merger and acquisition deals was 15 in 2014, up from 11 the year earlier, but down from 16 in 2012 (the peak year tied with 2010).

Private Equity (PE)

In addition, Sri Lanka has recently also seen a noticeable uptick in PE activity, which illustrates interest from a different category of investor. “The entrance of a top-tier PE firm into a country changes the entire landscape of a country, as these firms such as Blackstone and TPG have very rigid processes”, Alex Lovell, deputy chairman of Union Bank, told OBG. “The big challenge is selling the fundamentals of the country and explaining how the sector is going to grow,” Lovell continued.

In 2014, US-based PE firm TPG bought up to a 75% stake in Union Bank of Colombo – Sri Lanka’s eighth-largest bank by market capitalisation – for $117m. This deal was considered the largest buy-out of a Sri Lankan company in the history of the country.

Importantly, the regulators relaxed foreign ownership restrictions in financial services, normally capped at 10%. The move in many ways will counter the influence of the public sector in banking.

Following TPG’s initial success, the company signed its second Sri Lanka deal in late 2015, buying a 28% stake in Asiri Hospital Holdings from Actis. Asiri controls a network of four private sector hospitals in Sri Lanka, representing around 30% of all private sector capacity, and falls under conglomerate Softlogic Holdings. Actis initially invested in Asiri in 2012, and previously concluded deals with South Asia Gateway Terminals and Ceylon Oxygen.

Increasingly Sri Lanka has trended towards the establishment of local PE funds. In 2014, for example, NDB Capital launched a $50m Emerald Sri Lanka Fund, the largest of its kind in the country. The move is aimed to tapping into a large number of small and medium-sized enterprises with limited ability to raise equity due to their scale of operations.

Outlook

The stage is set for great changes in terms of laws, rules, regulations, incentives and institutions, and these will likely have a major impact on trade and investment in Sri Lanka. Taxes are likely to be simplified, foreign ownership of land amended and red tape reduced. At the same time, incentives will likely become rationalised and some potential reforms are inevitably going to hit political bottlenecks. The transformation will be tempered by the need for revenue and realities on the ground.

Sri Lanka’s investment environment is set to become more balanced, transparent and predictable, and this should help boost FDI as a percentage of GDP, as well as exports and balance of trade. As the country looks to broaden its investor base, it is hoped that these changes will attract the added investment needed to help the country reach its growth goals.