Sri Lanka is one of many countries covered by the iShares MSCI Frontier 100 Index Fund (FM), an inclusive Frontier Markets fund covering markets from Argentina to Vietnam. The countries in which this index operates provide a good guide to a list of many of the fastest growing economies in the world over the next few decades.
During my two week visit to Sri Lanka in October 2012, the most important questions to answer for prospective investors seemed a clear assessment of the risks of investing in Sri Lanka. Eleven questions were assembled to explore risk in Sri Lanka, and Deputy Governor Dr. P. Nandalal Weerasinghe kindly answered these questions in writing prior to meeting with me in person on 26 October.
Prior to assuming his Deputy Governor position at the Central Bank of Sri Lanka, Dr. Weerasinghe held an Alternative Executive Director position at the IMF in Washington, D.C. Many of these questions are the type of questions investors should ask about their investment in any country, though some are of course specific to Sri Lanka.
My written questions focused upon risk assessment as this process should be at the forefront of any investing process. When it comes to investing in emerging and frontier markets, readers are recommended to review the current U.S. State Department Investment Climate report on the particular country as these reports are written with assessing all possible risks for potential investors in mind. Thus, my series of articles about Sri Lanka begins by discussing the risks of investing there with Dr. Weerasinghe, Deputy Governor of the Central Bank of Sri Lanka.
Part 1: Written Q & A
(questions in italics)
GDP growth. Excluding the development of ports, and excluding oil & gas discoveries, what are the principal drivers that will keep Sri Lanka's GDP growth above 6% per year in the coming 10 years?
In addition to development of ports and airports, Sri Lanka has a huge untapped potential in the tourism sector where key international players are already expanding their activities all around the country. A comparison between Thailand and Sri Lanka back in the 1980s gives a good idea about Sri Lanka's potential in this sector. Other key growth areas are IT, accountancy services, engineering, architects, financial analysis, BPO services etc. Sri Lanka has an advantage in these areas over other countries in terms of well educated, English speaking youth population who can provide such quality services at very competitive rates.
In the industrial sector, there is a huge potential in value addition of tea, rubber, cinnamon, fishing and some mineral based industries particularly in the newly open Northern and Eastern provinces where there is lot of catching up to happen with other provinces.
Source: Knight Frank/Citi Bank Wealth Report 2012.
Higher GDP growth outlook. What are the time horizons investors should think about when considering possible development in Sri Lanka's potential high growth areas: port developments; oil & gas discoveries; expanding gambling opportunities for visitors (particularly from India, Pakistan and the rest of the south Asian peninsula); a bridge being built between Sri Lanka & India?
Sri Lanka has a natural advantage in terms of strategic location which is not only a key point between major shipping routes from the West to East and vice versa, but also will be the main entry point and hub for rapidly growing South Asian region. Some of the advantages investors can enjoy starting business are well educated, easily trainable work force, better infrastructure facilities by way of roads, ports, airports, uninterrupted power supply, easier to doing business compared to regional countries and huge potential in the areas mentioned above.
There will be opportunities open for foreign investors in oil and gas discoveries, deep sea fishing in relatively large economic zone belong to Sri Lanka and transshipment cargo, value addition, processing and bunkering in industrial zones established in Hambantota port and industrial zone and provision of recreational activity such as gambling, shopping etc for a rapidly growing middle class population in India. Property development in Colombo and major regional centers is another area with a great potential.
Sri Lanka is the island to the southeast of the southern tip of India. Red lines indicate the highest volume shipping lanes. Source: New York Times.
Currency stability. For foreigners, currency risk is a major factor affecting their total return from investments in Sri Lanka. Are there seasonal factors they should consider in Sri Lanka's currency valuation? What are the risks and possible causes for the currency to decline by more than 10% in a year? What is the prognosis for currency stability or appreciation?
Major factors for some instability in the currency in the past were higher fiscal deficits, higher inflation and larger current account deficits. The government and the central bank have introduced and incorporated major policy measures in order to achieve fiscal consolidation, low inflation and manageable current account deficits in the future. We have already seen the results of such measures which led to stabilizing the currency and domestic money markets. Going forward, Sri Lankan authorities have strongly committed to maintain macroeconomic stability which is the key anchor for stable exchange rates and interest rates which are instruments available for the authorities to absorb any potential external and domestic shocks.
Consumption, culture, and middle class. In what sectors are there opportunities for per capita income spending increases as per capita income rises? (e.g. further market penetration of cell phones, insurance, mortgages, luxury items, cars, gold & jewelry, etc.) Are there societal structures that will hold back growth of the middle class? In other words, what areas of the economy will see increasing conspicuous consumption as personal income rises; and what local cultural aspects foreigners may not understand could bottleneck both income growth and consumer spending growth?
Sri Lanka's middle income group is growing fast due to high economic growth and per capita income already reaching U.S. $3,000 and expected to exceed US $4,000 within the next couple of years. As income levels rise, the types of goods and services demanded by general public will naturally be changing. For example, demand for domestic tourism, higher quality and luxury goods and services are rising sharply and such demand provides new opportunities for higher value addition in the domestic economy. There are no social structures that could hold back a shift in consumption patterns as Sri Lankan society is more liberal thinking compared to the other countries in the region. There is no gender or religious gaps or restrictions in participation of economic activity in Sri Lanka and people very quickly would adopt new technologies, social values and spending patterns.
Shadow economy. The economy, currency stability and current account deficit partially rely upon remittances to Sri Lanka from Sri Lankans working abroad (primarily in the Middle East). How important is this labor force working abroad to the economy? In a slower year for the global economy that offers less employment to this group, what are the economic impacts on Sri Lanka to watch out for?
At present about 1.5 million Sri Lankans are working abroad of which a majority is in the Middle East. However, the share in the Middle East is gradually decreasing as employment opportunities in other regions especially in Korea, Malaysia and the Europe are rising. At the same time, there has been a shift towards more skilled labor from non-skill categories such as housemaids. This diversification of markets and labor categories has provided some cushion for external shocks and hence Sri Lanka has been experiencing steady increase in remittance flows even during severe slowdown in global economic conditions like in 2008/09.
Oil dependence and other risks. Many people point out that rising oil prices are a major risk to Sri Lanka's economic growth as oil is imported for energy as well as for automobiles. What are some hypothetical high prices of oil in USD and their negative impacts on the economy? (e.g. oil over $150/barrel = -5% to GDP) What are the next two risks to the economy after oil? What is being done to mitigate these risks?
Yes, oil price shock is a major risk not only for Sri Lanka but also for all oil-importing countries like Sri Lanka and therefore in relative terms, an oil price shock is not likely to have an adverse impact in terms of competitiveness of the economy. However we are very conscious about the absolute impact of such a shock and we are taking measures to reduce oil dependency in the medium term. For example, currently our power generation is largely a mix of hydro and thermal fuel like heavy fuel and diesel with a ratio of 40:50 during a normal year and about 10% from coal. We are in the process of diversifying generation mix by adding more low cost coal, LNG and non-renewable energy so that our dependency on high cost thermal fuel like heavy fuel and diesel are expected to come down to around 10%. With the implementation of this plan, we would be able to improve our competitiveness in terms of cost of energy.
Tsunami and earthquake risk. The tsunami of 2004 is an unforgettable tragedy. Although investment professionals are not weather reporters, investors want to feel informed about the possibility of a future tsunami, and the impact it would have on the economy. Additionally, it has been written that the tsunami was a sign of a shift in the earth's tectonic plates which has caused there to be more earth tremors in Sri Lanka since the tsunami. Is Sri Lanka monitoring these tremors to be aware of any increased risk of earthquakes? How concerned should investors be about tsunami and earthquake risks?
Our preparedness for natural disasters has improved substantially since the Tsunami which was totally unexpected and most Sri Lankans hadn't even heard the word Tsunami at that time. Not only has Sri Lanka recovered very fast from the adverse impact of Tsunami, we have now in place the most modern Tsunami alert systems by which we can evacuate people within few hours of a tsunami alert but also we have built structures along the coastal belt that are more resilient to such shocks. We now have a separate ministry for disaster management which continues to build systems and take mitigation measures to minimize damages from floods, landslides, droughts and other natural disasters.
LTTE risk (Liberation Tigers of Tamil Eelam were the opposition to the government in Sri Lanka's civil war; the LTTE was based in the north and east of Sri Lanka). Sri Lanka has had peace for three years since the end of a nearly 30 year civil war. What are the risks of future acts of terrorism against the government? How much damage to the economy could one isolated terrorist attack do?
The possibility of having even an isolated terrorist attack is very remote now. Now people in the North and East are eagerly looking forward to better livelihoods and new economic and social opportunities toward the betterment of their living standards. The government is rapidly developing infrastructure and enabling an environment for them to engage in their normal economic activities, and provide opportunities for them to democratically elect their own representatives in provincial governments and local governments. The government is also implementing measures recommended by the LLRC to address any grievances that led to the conflict in order to make sure there would be no such conflicts in the future. [LLRC = Lessons Learnt And Reconciliation Committee]
Corporate governance. What is the quality of accounting and financial reporting standards investors can expect? What authorities regulate the reporting, and do they have a record of enforcing regulations? For the second year in a row, Sri Lanka's Business Today magazine October 2012 edition has taken it upon itself to rate the top 25 companies in terms of corporate governance to encourage better practices across those companies lagging; could you provide more examples of how good corporate governance is becoming a cultural value?
During the last few years, we have introduced several corporate governance reforms in line with international best practices particularly in the financial sector. In addition, corporate and financial reporting standards are on par with international standards. The government is also considering bringing in governance reforms to corporate sectors outside the financial sector as well. All public listed companies should have very stringent governance and accounting standards which are regulated by the SEC.
Foreign Direct Investment [FDI]. What business opportunities will bring more Foreign Direct Investment to Sri Lanka? How important is increasing FDI to improving GDP growth? On the opposite side of the coin, if the global economy slows and Sri Lanka's FDI goes down as a result, what are the risks to Sri Lanka's economic outlook?
In Sri Lanka, we have a very liberalized FDI regime where almost all sectors are open for foreign investments without any ownership restrictions. At the same time, there is a constitutional guarantee for the protection of rights of foreign investors and there are no restrictions to repatriate profits, dividends or even the capital. In addition there is a very attractive tax incentive structure for large strategic investments and the Government is taking necessary measures to improve enabling environments by making it easier to do business in Sri Lanka and developing necessary public infrastructure to improve productivity of investments and to improve competitiveness of production processes. With regard to areas of investment with huge potential, tourism, port and airport related activities, petroleum exploration, higher education, agriculture, fishing, and value addition in industrial and agricultural production are a few key areas. A slowdown in the global economy would obviously have an impact on FDI inflows to all emerging market countries but given new opportunities in Sri Lanka for foreign investors, Sri Lanka is well placed above most competitors in the region.
Export growth. A lot of Sri Lanka's exports currently go the U.S. and Europe, but the faster growing economies are elsewhere. What is Sri Lanka's strategy for developing markets for its exported goods in Asia, the Middle East, South America and Africa? How will Sri Lanka grow those markets for its exports?
We are increasing our integration with regional markets for exports especially with India, the Middle East and Russia which are growing markets. There has been some shift towards Sri Lanka, especially in garment exports, due to rising wage costs in China and some other bottle necks in countries like India, Pakistan and Bangladesh. Sri Lankans exports as a percentage of GDP has been coming down in recent years mainly due to rapid expansion in the domestic economy due to new opportunities which arose after the end of war, and a huge infrastructure drive initiated by the government. In absolute terms, we have been having continuous growth in exports except for this year due to the slowdown in the U.S. and EU markets. The current projections suggest that those markets are gradually recovering and our exports are now well placed to take advantage of these opportunities and reap benefits out of improved macroeconomic stability by way of low inflation, higher capacity in the economy with much improved infrastructure, better environment for doing business and greater flexibility in exchange rate.
Part 2: Discussion
After receiving written responses from Dr. Weerasinghe by e-mail, we met on October 26, 2012, in his office for a follow-up conversation. Over two hours, this conversation was wide ranging and below is a compilation of our discussion organized by topic.
On energy. Sri Lanka is working to expand the use of coal power plants, liquefied natural gas and hyrdopower. Sri Lanka is actively looking for a steady supply of coal as they look to expand to 1500 megawatts of coal power plants from 300. Sri Lanka has only one oil refinery that was put in to refine Iranian oil with the help of previous Iranian regime which was a strong U.S. ally. The refinery can only refine oil with the particular qualities of Iranian oil which means as of today, with the global embargo against Iranian oil, Sri Lanka will have to import a larger portion of its petroleum needs in refined form (as opposed to refining 50% of domestic demand at the domestic refinery). Therefore, the state-owned petroleum corporation is earning less income from refinery margins. The refinery needs to be modernized to be able to refine oil from other countries, but until recently there was never the need to do so. The private sector is encouraged to invest in refinery capacity. There has been some early stage propositions for building a refinery near the new port of Hambantota with potential to have capacity not only for the domestic market, but also refined oil for export and bunkering.
On tourism. If you compare Sri Lanka to Thailand in the period of 1980 to 1983, both countries had about 500,000 tourists per year. Now Thailand has about 10 million tourists per year while Sri Lanka is aiming for 1 million tourists this year. If it were not for Sri Lanka's civil war, this number would be higher. Now that the war is over, the potential is there.
On ports. With a vast quantity of shipping lanes passing 11 km to the south, there is the potential for Sri Lanka to become a regular stopping point for ships. Moreover, there is the potential for Sri Lanka to be the pivotal transshipment point between the Indian Subcontinent and the rest of the world.
Colombo is Sri Lanka's capital and major port on the white island (Sri Lanka) at the bottom of this map. Source: India Maps Online.
On Hambantota airport and shipping port. These are both new initiatives. The airport will be the nation's second international airport to cater to Sri Lanka's growing international airport traffic. The new port of Hambantota along the southern coast is one of many government initiatives to cater to increasing sea port traffic.
On the Sri Lanka workforce. On the World Bank's doing business index, Sri Lanka is #89, the highest in South Asia (Bangladesh is #122, India is #132, Pakistan is #105, Bhutan is #142, and Nepal is #107). Compared to the rest of the region, Sri Lanka is well placed. Sri Lanka has strengths in terms of its developed infrastructure and its labor force's skill set. The people of Sri Lanka are not just looking for survival, but for an improving quality of life.
On wage growth. GDP growth will lead to wage growth. In areas such as construction where labor capacity is being used up, wages are rising faster. In response, the construction industry is being modernized by using new technologies in order to improve productivity. Several other labor intensive industries are also following the same trend in order to remain competitive.
On tea and tea plantations. Ceylon tea (Sri Lanka was formerly named Ceylon) sets the global price. Technology on the tea plantations will need to change to improve profitability. Low wages earned by people picking the tea on the plantations is unsustainable (currently on average below $5 per day). Owners of plantations want wages to be tied to productivity whereas unions want raises tied to time worked. For both tea and rubber plantations, it is possible Sri Lanka will have to import cheap labor in the future (much like the Mexican agricultural labor force in America). While India exports around 10% of its tea production, Sri Lanka exports 90% of its product. Along with Kenya, Sri Lanka is one of the world's two biggest tea exporters.
Source: Maps of world.
On rubber. The price of rubber is linked to petroleum prices. In the past, Sri Lanka exported raw rubber. Now, Sri Lanka is doing more finished products. While there used to be 90% of rubber exported in the raw, 35% of rubber exports are now finished products and that number is growing.
On timber. Essentially, for reasons from scale to domestic use, timber production is already near capacity. Sri Lanka is committed to protecting it's rain forests.
On mineral deposits. There are limestone and graphite deposits that have not been exploited in the north and east. (For those that don't know, some of the finest gem stones in the world come from Sri Lanka, however this is a small part of the economy.)
On agricultural growth. Most cultivatable land is already in use. There is room for additional capacity in the north and east where the civil war was. The north and east, 1/3 of Sri Lanka's land mass, was at one time controlled by the LTTE during the civil war. It is the dryer part of the country, but in many places there are functioning irrigation systems still intact from Sri Lanka's ancient civilizations. The new land available for cultivation in the north and east of Sri Lanka could be used to increase agricultural production.
On food self sufficiency. The country is self-sufficient for most of its food needs now with the exception of wheat and some dairy products. The country is working toward dairy self-sufficiency and will achieve it. Wheat cannot be grown in the country, but as the country develops toward being a net exporter of rice, there are clearly available substitutes to wheat.
On corporate governance. Sri Lanka is working toward improving corporate governance in the financial sector. These improvements will be used as models for the whole private sector. Only 10% of Sri Lankan companies are publicly traded on the Colombo Stock Exchange, and this number should rise.
On consumer spending. India and Bangladesh have more of a culture of saving and buying gold. People who live in the north of Sri Lanka are more inclined to save in this way. The people who live in the south and west of Sri Lanka have spending patterns that are changing toward being more like Western people as their income levels are rising at a faster rate. Therefore, demand for luxury goods and services are rising in that part of the country. This trend is expected to keep consumer demand in line with higher economic growth in the future.
On the gender gap. There is less of a gender gap between men and women in Sri Lanka than in regional peers. Economic opportunities for women in Sri Lanka are liberalizing and women are paid comparably. Sri Lanka has increasing participation from women even in top positions in the government and private sector. For example, the Central Bank has had several female deputy governors. We also see an increasing trend of female recruitment of qualified graduates to the Central Bank of Sri Lanka.
On Sri Lanka's reserves. Sri Lanka's primary reserve currency is the U.S. dollar because it is the major trading currency not only with the U.S. but also with several other emerging market economies. Sri Lanka also holds a number of other currencies in reserve for diversification including sterling, euros, yen, Aussie dollars, yuan and gold.
On integration between (the minority) Tamils and (the majority) Sinhalese. Integration between the north and east of the country, and the rest of the country is progressing fast. Younger generations are and will see fewer differences. For the people of Sri Lanka, the environment after the civil war is a new start. As Dr. Weerasinghe's time with the IMF in Washington D.C. spanned from 2009 (the year the war ended) until 2012, upon returning home he could see a huge change in the country. Where there were once many security checkpoints on his way to work in the central business district, there are now none. The people who live in the north and east of the country are very hard working, and working to redevelop their parts of the country, from agriculture to tourism.
On China. China is a close ally of Sri Lanka. China supported the Sri Lankan government during the civil war. There are both government investments from Chinese firms and loans from China. The Sri Lankan government will own its ports and power plants. For public infrastructure developments, the Chinese government provides financial assistance by way of loans in most cases. In terms of Chinese investment, they are building a terminal at the port of Colombo, a new very large hotel, and these are thing they will own and operate like any other private sector project funded through foreign direct investment.
On keeping the economy stable. The government and the Central Bank took steps to cool the economy off in 2011 and 2012. After the civil war, people in the country, and foreign investors, were very excited about Sri Lanka's potential. 2010 saw 30% credit growth and 2011 saw 35% credit growth. GDP was growing in excess of 8%. There were two consecutive years of growth over 90% on the Colombo Stock Exchange (2009 & 2010). This was too much and not sustainable. Now, things are cooling off. Going forward, the Central Bank of Sri Lanka anticipates more sustainable and steady growth rather than boom bust cycles.
On the fiscal deficit. During the civil war, the fiscal deficit was around 9 to 10% of GDP annually. The fiscal deficit is now being reduced annually, as is the debt to GDP ratio. The deficit is stabilizing at around 6% with this year's GDP growth targeted to be 6.2% (but possibly as high as 6.4%). Going forward there are probably 3 or 4 more years left with a deficit at 5% or higher, and thereafter maintaining a deficit below 5% is sustainable alongside annual GDP growth of 6% to 7%.
On the capacity for growth. It is challenging to estimate the potential rate of economic growth as the economy's structure is changing. The capacity of the country is growing with the expansion of infrastructure from an improving network of roads and highways, to increased airport capacity, to the development of ports, to a large number of industrial zones (Sri Lanka's Board of Investment has an excellent summary page on Sri Lanka's developing infrastructure and another page listing current industrial zones). Dr. Weerasinghe believes the increasing public investment in infrastructure will lead to increased capacity that will grow the country's economy.
On communication between government agencies with the economy's best interest at heart. The Central Bank has regular dialogue with the secretaries of the Ministry of Finance and business sector. Fiscal coordination with the government is important as Sri Lanka has a large fiscal deficit. The Central Bank works with other government agencies in a consultative process. There must be consideration of how the government's budget is financed and other details before determining monetary policy. The organizational structure of the Central Bank of Sri Lanka includes going through its Monetary Board made up of the Governor of the Central Bank, the Secretary of the Ministry of Finance, and three members from the private sector, who together independently decide on monetary policy. Major policy recommendations are made to the Monetary Board by the monetary policy committee of the Central Bank which is chaired by Dr. Weerasinghe.
We thank Dr. Weerasinghe for sharing his wealth of knowledge and experience with Seeking Alpha's readers.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.