Sri Lanka's new pro-business government creates economic opportunities

Sri Lanka prospered under its former president, Mahinda Rajapaska, a figure who is credited by many with ending the civil war and practising a highly directed, centralised style of management. During his tenure GDP growth remained high, rising over time and, despite some volatility, stayed positive throughout his administration. Now, the country is entering a period in which it stands to grow rapidly under what has been described as a more liberal, open and business-oriented government.

The new leadership is addressing some of the more negative legacies of its predecessors and is beginning to introduce policies that will help bring about strong and sustainable growth. Observers see some challenges in the near and medium terms: reforms will come with costs, and the tempering of the China-led construction boom and uncertainty surrounding the elections impacted growth in 2015. The new government does have strong populist tendencies that could also affect the economy. Sri Lanka needs, especially, to keep an eye on the debt and deficit and defend against external shocks. Overall the sense is that the country is well set for future growth under the current leaders and that it will be able to overcome any challenges or surprises it faces. “I am very optimistic and charged up about this country’s long-term prospects,” Lakshaman Bandaranayake, publisher of Lanka Business Online, told OBG. “Sri Lanka is a resilient country.”

High Growth

The Sri Lankan economy has been growing well recently despite a degree of political uncertainty and the global slowdown in emerging markets, with GDP expanding on average more than 6% since 2010. The Asian Development Bank (ADB) is expecting full-year growth of 5.3% in 2016. Actual growth in the first three quarters of 2015 averaged 5.2%. GDP has been rebased with a 2010 base year, and this has caused the 2013 and 2014 GDP to come in lower than originally reported, but it also led to a revision upwards of the 2011 and 2012 numbers. Whichever base is used, however, the economy has been growing rapidly since 2010.

Inflation

Importantly, inflation – as measured on the Colombo Consumer Price Index – has been tamed and went from being one of the major economic issues for the country to an afterthought throughout 2015. Consumer price index growth hit nearly 30% before the economic crisis of 2008 and spiked again in 2013 to 10%. Between 1986 and 2015 the rate of inflation averaged 9.91%. However, since 2013, it has been falling. Sri Lanka actually experienced deflation during a three-month period in 2015: July (-0.2%), August (-0.2%) and September (-0.3%). By the end of 2015, however, the rate was back up, at 3.8%, and the World Bank expressed concern that the depreciation in the currency will begin to feed through into inflation. The ADB sees inflation returning to 4.5% in 2016 due to rising food prices. By January and February 2016 inflation was at 0.9% and 2.7%, respectively, according to the Department of Census and Statistics. The Central Bank is targeting 3-4% inflation for the whole of 2016.

The decline in prices is to a certain extent the result of repeated cuts in fuel prices. In January 2015, a litre of 92-octane petrol dropped from LKR150 ($1.08) to LKR117 ($0.84), while a litre of kerosene went from LKR81 ($0.58) to LKR65 ($0.47). This decision followed earlier cuts in fuel prices. The government has insisted that the moves were made to follow the trends in global oil prices, and to allow the commodity to begin to follow the international market.

The economy is seen to be shifting from one focused on investment to one more consumption oriented, according to the ADB, as inflation has slowed and as the public has become more willing to spend. Consumer confidence hit an all-time high of 88% in October 2015, according to a survey conducted by Nielsen. Sri Lankans are optimistic about the future state of their personal finances and believe they will have more disposable income amid falling inflation and encouraging government policies.

In terms of the individual, the economy has broken through a number of key thresholds in recent years. GDP per capita was estimated at $3794 in 2014, up from $869 in 2000. In 2010, the country was reclassified as a middle-income-emerging market by the IMF, being upgraded from a “poverty reduction and growth trust” eligible country. Sri Lanka is now well on its way to becoming an upper-middle-income country. The IMF notes that since the conflict ended in 2009, the conditions in the country have improved considerably for individual Sri Lankans, with inflation falling, new economic activity increasing and infrastructure improving at a rapid pace.

Interest rates have been coming down steadily for a number of years. The standing deposit facility rate (SDFR), one of the main policy rates, peaked at 10.5% in 2007. Cutting started in early 2009 and has continued, with the SDFR reaching a low of 6% in April 2015. The April 2015 cut was considered a surprise move, with the central bank slashing rates by half of a percentage point. This move was intended to lower the cost of money for businesses and was made possible in part by the lack of inflation. However, some critics have argued that the cut threatened an already weak balance of payments position, and in early 2016 the central bank returned the SDFR to 6.5%, as well as the benchmark rate to 8% (see Banking chapter).

Production

Agriculture has had a slow few years, with the overall index for the sector (as calculated by the central bank) stalling. It was 116.8 in 2012, rising to 121.9 in 2013 and then dropped back down to 119.9 in 2014 (2007-2010=100). Plantation production has been stagnant, with the index dropping from 106.7 in 2012 to 97.4 in 2014 before jumping up to 109.7 in the second quarter of 2015. Rubber is down, from 113.3 in 2012 to 64 in the second quarter of 2015. Tea production in 2015 is estimated to be lower than in 2014 because of heavy rains. A few categories in the agricultural sector have done well. The rice index is up, from 102.8 in 2012 to 108.3 in the second quarter of 2015, while the vegetable index rose from 117.4 to 162.2 in that same period.

Industry has been an engine of growth for the economy, according to central bank statistics. The overall sector index rose from 108.8 in 2012 to 123.7 in June 2015. Apparel has been the most active, rising from 118.5 to 166.6. Rubber and plastic products rose from 116.6 to 141.2. Most other categories in the industrial sector, however, have been relatively stagnant, with fabricated metal products, for example, dropping from 111.7 to 86.

Transport

The transport sector has been growing quickly in recent years as well. Total twenty-foot equivalent units handled by the country’s ports rose from 3.9m in 2012 to 5.2m in 2015. Passengers carried by Sri Lanka Railways rose from 5m in 2012 to 6.8m in 2014. The passenger car business has seen particularly strong growth. The number of registered motor cars rose from 31,536 in 2012 to 38,780 in 2014. The increase in 2015 was extraordinary, with three-fold growth: in the first quarter of 2015 alone, some 18,540 cars were registered, compared with 6332 in the same period a year earlier, due primarily to a relaxing of import duties. In the second quarter, the number was 21,155 compared with 7439 in the same period of 2014. In July 2015, the number was 10,452, compared with 3236 a year earlier. The building permit index was likewise up considerably, jumping to 116.9 in the second half of 2015, compared with 106.7 in 2014 and 100.5 in 2012.

Tourism & Remittances

One key element of the economic equation has held up particularly well; earnings from tourism are especially strong, rising from $350m in 2009 to $2.4bn in 2014. The trend continued into 2015, bringing in $2.9bn, an 18% increase based on record arrival numbers topping 1.8m. Remittances, however, which remain a vital part of the economy, seemed to have stagnated of late. While they hit a high of $7bn in 2014, 2015 has not kept pace, contracting 0.5%to $6.9bn. This decrease is in contrast to 2013 and 2014, when growth rates were 7% and 9.5%, respectively. The drop in remittances is a reflection of lower oil prices and slow hiring in the GCC (see analysis).

The Deficit

Sri Lanka’s economy remains unbalanced, but the numbers are improving. The current account deficit has narrowed significantly in recent years. It went from $3.98bn in 2012 to $2.54bn in 2013 and to $2.01bn in 2014. In the first quarter of 2015, the current account deficit was $391m, compared with $459m in the same quarter a year earlier. The IMF calculates that the current account deficit as a percentage of GDP fell from 6.7% in 2012 to 3.7% in 2014. Sri Lanka’s debt to GDP ratio has been coming down steadily as well. It has fallen from above 100% in the early 2000s to around 74% in 2015. The fiscal deficit has grown from 5.3% in 2013 to an estimated 7.2% in 2015. A 5.9% budget deficit is projected in 2016 under the budget delivered in late 2015. But a decline in the country’s foreign exchange reserves in 2015 and early 2016 has led to worries that a balance of payments crunch could impact the fiscal position throughout the coming year. The government is also likely to face pressure on foreign borrowing due partly to a rise in US interest rates.

Fitch Ratings is sceptical of the government’s ability to get its fiscal house in order. It notes, in comments made in November 2015, that the official 4.4% deficit goal for 2015 will be surpassed by a considerable amount, and was not convinced that the government has much credibility in meeting its targets.

Surprisingly, Sri Lanka’s deficit has increased despite the decline in international oil prices. Oil imports represent one of the single largest components of Sri Lanka’s overall import bill, with hydrocarbons – including coal, gas and oil – contributing around 42% of the country’s energy supply, depending upon the year and weather patterns. The savings accrued from the decrease in oil prices should therefore have translated into significant savings on Sri Lanka’s balance of payments. However, these savings have largely been offset by an increase in consumption of imported goods, spurred by cheaper credit and a hike in public sector salaries.

Revenues

Deficits are exacerbated by the fact that government revenues as a percentage of GDP have gone from 22.43% in 1990 to 12.2% in 2014. Fitch advises that, to increase revenues and close the fiscal gap, the government needs to undertake difficult reforms that it has thus far been unwilling or unable to enact. Meanwhile, the ratings agency forecasts a worrying rise in expenditures, which it says will hit 22.3% of GDP in 2016, up from 19.1% a year earlier, due to higher spending commitments in health care, education and infrastructure. “The decline in government revenue to GDP ratio has been a major concern in the fiscal sector over the years and it has decelerated to 12.2% of GDP in 2014 from more than 20% achieved prior to 1995,” according to the government’s “Fiscal Management Report 2016”.

Others say such fears are overplayed. Some observers and analysts contend that, such as it is, the debt does not set off alarm bells: high it may be, they concede, but the government is managing it well and is capable of servicing it. Central bank officials further observe that Sri Lanka has never defaulted on its obligations, and insist that it is still able to pay its debts. They point out that much of the debt is held locally and therefore can be rolled over. The central bank similarly plays down comments that the government took on a lot of expensive debt from China, arguing that it has borrowed from a wide range of lenders and that the interest rates offered by the Chinese were not out of the line with global market trends at the time the debts were contracted.

Among investors, however, concerns persist. To be sure, the public works projects carried out in the last half-decade have added value to the economy and made it more efficient. The worry is that high levels of borrowing leave the country vulnerable to outside economic pressures. While Sri Lanka’s debt levels are far from those of emerging markets such as Mexico or Argentina, one issue affecting its sovereign credit rating is vulnerability to external shocks. Despite much positive sentiment about the country’s economic prospects, a series of events in early 2016 have highlighted the country’s fiscal weaknesses. Sri Lanka lost around $1bn in foreign reserves in the month of January 2016 alone. In February the government solicited support from the IMF, and Fitch lowered the country’s sovereign rating from BB- to B+. Needless to say, issues around balance of payments should prove paramount throughout 2016.

To ally such concerns, the government sees a number of avenues for action. In early April 2016, it asked China to restructure some of its debt, converting some of the $8bn it owes to Chinese institutions into equity shares and stakes in local firms. How Chinese officials would respond was still unclear, but a number of meetings between the two countries were on the agenda. Officials also note the presence of many non-China lenders, and Sri Lanka aims to balance its debt among multiple players and reduce dependence on any single party or country (see analysis).

Breakdown

Sri Lanka’s economy is divided primarily between, and dominated by, large private holding companies with operations in multiple sectors of the economy, and an expansive state sector. On the government side, two state banks – Bank of Ceylon and Peoples Bank – hold around 40% of all banking assets in the country, while others, including National Savings Bank, the Housing Development Finance Corporation, and Sri Lanka Insurance, the largest insurance company in the country, occupy various niches in financial services. The government protects airports and aviation with almost full ownership of the national carrier, SriLankan Airlines, the low cost carrier Mihin Lanka, and Bandaranaike International Airport, which is run by the Airports and Aviation Services. It owns Ceylon Petroleum Corporation – the national oil marketer – as well as the Ceylon Electricity Board, which controls most generating and all transmission and distribution assets. Many of these institutions have grown to be significant burdens on the treasury in recent years.

Reform

Following parliamentary elections in August 2015, the government established the Ministry of Public Enterprise Development to help restructure the country’s state-owned enterprises portfolio, and make their institutions more transparent and efficient. Hints were also given in the 2016 budget that the government would begin selling down its stake in assets deemed non-strategic. However, the public, as well as vested interests in the government, remain averse to any kind of full-scale privatisation, a mindset many claim was instilled by the former administration. Many of Sri Lanka’s public institutions face challenges with efficiency, being overstaffed and a means to absorb unemployed or underutilised labour. A Public Sector Employment Survey conducted by the central bank noted that public sector employment grew by 3.2% to 1.3m in 2014, representing about 6.5% of the population.

Yet Sri Lanka’s private sector remains quite dynamic, led by John Keells Holdings and Hayleys Group, the two most dominant and diverse enterprises, both with historical roots going back over a century. John Keells Holdings, the largest listed holding company, began as a produce and exchange broker in the 1870s. Today, it accounts for a market capitalisation of over LKR180bn ($1.3bn), or about 7% of the Colombo Stock Exchange, with operations in virtually every part of the economy, including the manufacture and distribution of consumer foods, hospitality, transport, manufacturing, retail and property development. Cinnamon Life, a major mixed-use development expected to complete construction by 2019, is touted as the largest private sector-led investment in the country. Hayleys Group, Sri Lanka’s second-largest conglomerate, started operations in Sri Lanka in 1878 and expanded with manufacturing facilities in Indonesia and Thailand and marketing operations all over the globe. The group accounts for 3.71% of Sri Lanka’s export income, 4.5% of tea, and 2.2% of rubber production. The country also has a growing portfolio of SMEs, and 300 companies listed on the Colombo Stock Exchange.

Political

While the election of the new government has been met with optimism, some concerns remain, which effectively created a “wait and see” approach in Sri Lanka’s private sector throughout 2015 and into 2016. Construction spending is bound to slow as the new administration examines the infrastructure policy of its predecessors and shifts toward more balanced investment. The ADB sees the possibility of weaker private sector investment on policy uncertainty inevitable with the change in leadership. The new government has also warned that as it looks into the books and begins to take aim at accounting irregularities, there will no doubt be some growth lost along the way.

Particular attention has been paid to the investigation of Chinese investment projects. Under the Rajapaksa administration, a priority was put on getting projects finished and the country rehabilitated. China obliged with generous financing for all manner of infrastructure. Much of this funding has now come into question as a result of the new government’s approach to dealing with potential corruption cases, as well as the costs and waste in some projects. Some of the projects, such as roads, have been praised, but others are attracting criticism.

Audits

Among the projects brought into question are the Magampura Mahinda Rajapaksa Port, the Mattala Rajapaksa International airport and the Colombo-Katunayake Expressway, which may be the most expensive highway ever built (see Transport & Logistics chapter). The government began auditing state construction projects to see if they were properly awarded, placing several on hold. Towards the middle of 2015, it relented in its position somewhat and some projects under review began to move forward. Two roads were reported to be proceeding as planned, and in early 2016 the government gave the green light to the $1.4bn Colombo Port City project, which had been delayed because the Chinese contracting company, China Communications Construction, had been promised freehold land.

The new government has also said strategic development projects could no longer include casinos, putting an end to a new growth area. The casino component of a $400m project by Crown Resorts of Australia was disallowed, as was a planned casino in the $300m Queensbury resort project. John Keells Holdings planned to rent out a casino as part of the retail space in Cinnamon Life, a waterfront project, but this was also cancelled. The government had also planned to impose a $100 levy for each person entering a gambling establishment, before this policy was scrapped in November 2015. However, the annual levy on casinos themselves will be increased from LKR200m ($1.4m) to LKR400m ($2.9m) and a 25% surtax on gaming profits will be added. The interim 2016 budget had called for a one-time LKR1bn ($7.2m) tax on the country’s existing casinos.

Fiscal Health

The new government also has a delicate balance to strike between domestic policies and the concerns of international lenders. Besides cancelling the casino licences, which has created uncertainty in other sectors as well, it has raised public salaries and introduced a windfall tax. While the international community has welcomed the new government, such populist measures can spark worries among the multilateral institutions such as the IMF that monitor the country’s fiscal health.

The 100-day mini-budget initiated by President Maithripala Sirisena cut prices for some essential commodities and mandated higher spending on health care and education, while bringing in new taxes to raise new revenue. These measures provided a significant boost while the government mulled further steps for its 2016 budget. Released in November 2015, the 2016 budget simplified the corporate tax system to two rates: 15% for agriculture, services and manufacturing, and 30% for financial institutions and other trading activities (a 25% surtax is levied on gaming, liquor and tobacco). It also established a range of tax incentives, such as on dividends, interest income and certain agricultural activities, while also taking steps to improve revenue collection (see analysis). As of March 2016, the government was working with the IMF to further revamp the tax code.

Long-Term Questions

Sri Lanka is facing its share of challenging underlying trends. Its demographic bonus period – the time in which it has had a high percentage of young, working-age people compared with its aged population – is fast coming to a close. This period was seen to run from 1991-2017. The bonus period was the result of highly successful programmes that reduced mortality and allowed people to live and work longer, and it was a time in which Sri Lanka had, and still has, an opportunity to make the investments and encourage the activity that will allow the country to grow and develop.

Many industries from plantations to garments to ICT are already experiencing labour shortages, however the general public remains averse to any importation of foreign labour to fill gaps in the work force.

Additionally most enterprises cite archaic labour laws as a major challenge to business operations in Sri Lanka. While most concede modernisation is required, political roadblocks have traditionally dismantled efforts at reform. Trade unions, particularly around plantations, remain highly politicised, increasing the likelihood of strikes.

Outlook

The new government has been left with an economy with great potential but one burdened by debt and lacking the types of investment to see it through to the next stage. It has to grow, not only in order to pay down its debts but also to avoid the middle-income trap. Sri Lanka occupies an intriguing place on the world stage. Analysts have been encouraged by the fiscal choices of the previous government and the current leadership. Its economy has grown at a rapid pace, but questions remain as to where it will go from here. Likewise, it must avoid an overheating situation, which causes problems down the line. Observers say that the only choice is reform. If the government wants to achieve the growth necessary to bring down its debt, it is going to have to undertake significant structural changes. Luckily the current government appears poised to do just that.

Sri Lanka has developed new avenues for significant growth, such as its burgeoning tourism sector, and investments in shipping and infrastructure. If the country can build on the steps it has already taken, there is no reason why it will not continue to grow.