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Moody’s raised Sri Lanka’s sovereign rating outlook to Positive from Stable over the weekend, projecting sustainable growth rates of around 8-9 percent over the medium term on the back of a “peace dividend that has accrued to the economy and the security environment”–part of which stems from the tangible addition of the country’s now-bloated armed forces (which tripled in number during the recent civil war) from security and service work to “development work” (which certainly beats them having to address tough questions from pesky panelists).  Per some observers Sri Lanka still faces “a number of challenges including high fiscal deficit, lack of infrastructure (though the aforementioned military can help address that) and high dependence on short-term foreign financing”–though we quibble which much of that premise and agree with Barclays that a closer examination suggests an imminent, one-notch upgrade in the sovereign rating later this year to low BB, given “strengthening external balances, rising investment and progress on fiscal consolidation.”  Indeed, while the trade deficit will likely continue to deteriorate this year given commodity prices, the trend not only looks to be stemming but hitherto supportive remittances and FDI flows continue to keep the overall balance of payments in an advancing surplus.  Analysts note, for instance, that despite tensions in the Middle East (which accounts for the bulk of remittances) inflows were up 28% y/y in Q1 while FDI inflows, meanwhile, were up 160% y/y during the same period and look directly correlated to tourist arrivals (up 50% in 2010) and overall tourist revenues which, while currently roughly 1% of GDP “could easily double over the coming two to three years.”  Turning to the fiscal story the government appears committed enough to capping current expenditures at roughly 7% of GDP, while tax-simplification measures contained in the latest budget should augment revenue collection and lower the oft-cited public debt to GDP measure under 80%, a development which, coupled with the state’s plan to raise 4x the amount (versus last year) of its financing from domestic sources (up to ~78% projected) in lieu of external ones, should go a long way in addressing an admittedly large and growing debt overhang and determining its ultimate sovereign credit status.  Finally, per monetary policy sticky core inflation numbers to date given in part this spring’s fuel price hike and electricity tariff adjustment as well as ever-mounting FX reserves ($USD7.1bn in early June versus the low of $USD1.3bn in early 2009) will likely see the central bank (CBSL) willing to accept a stronger LKR as the primary normalization tool (assuming annual inflation remains somewhat muted and hovering around 8.0-8.5%), thus keeping policy rates (since January’s 50bp cut repo and reverse repo rates sit at 7% and 8.5%, respectively) unchanged and post-war growth rates that much more unfettered.  In sum, Sri Lanka is poised to outperform emerging-Asia peers as its post-war paradigm continues to unfold.

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Only six markets worldwide are trading above their 2007 highs, and all of them can be classified as “frontier,” per a recent piece from the Wall Street Journal:

Tunisia, the tiny African nation south of Italy, has been the best performing stock market since 2007. The Tunindex, a 12-year-old index of 45 stocks, is trading 81% above its high for that year, and is up 15% for 2010. Sri Lanka is up 53% since 2007 and 36% this year.  The other four comprise Venezuela, Colombia and Chile— Latin American countries benefiting from a rush to commodity-rich emerging markets—and Indonesia.

The tally of performances demonstrates just how much investors have been favoring emerging markets, and the extent to which they have been willing to delve into frontier markets.

Emerging market mutual and hedge funds saw inflows of $17.3 billion in the first half of 2010, while frontier markets saw $780 million incoming.  Fund managers, the theory goes, are increasingly turning their attention to such markets if for no other reason that growth rates there are expected to vastly outperform those in developed countries.

The true test, of course, will be the viability of any long-term paradigm shift.  Are money managers merely opportunistically seeking short term alpha, or are these shifts the beginning stages of a more concerted, long-term effort at mirroring what many observers predict will be a fundamental change and rebalancing in global finance whereby the relative fiscal strength of developing markets is reflected in higher exchange rates and greater consumption and foreign investment, fueling in turn a virtuous cycle and greater liquidity in their risky assets?

Leopard Capital, which we profiled in the past, will take to the road in March to raise funds for both of its Sri Lankan-oriented funds–the Sri Lankan Fund LP, “a 10 year private equity fund targeting US$100 million [that] will primarily take minority positions in unlisted companies, targeting post-war growth sectors such as tourism, food processing, fisheries, consumer products, and retailing,” as well as a Value Fund, which will hold “both a core portfolio of smaller, overlooked ‘deep value’ stocks, and a trading portfolio of blue chips.”  Both funds will be run by its newly formed Sri Lankan division.  The firm also recently announced that Jim Rogers, the Singapore-based investor, author and commodity permabull, will join Marc Faber on the firm’s advisory council.  That’s a pretty nice duo to headline your pitchbook. 

Following the resounding reelection of President Mahinda Rajapaksa in late January–a surprising affair to many observers both in its relative peacefulness and its marked decisiveness–optimism is abundant for the long-time, civil war plagued island.  As The Economist noted:

The economy, buffeted by a slump in garment exports and tourism because of the war, is perking up.  This year the country is expected to see some 600,000 foreign tourists, compared with 500,000 last year.  The New York Times has named Sri Lanka its top tourist destination for 2010.  Annual remittances, mostly from hardworking Sri Lankans in Arab countries, have rebounded from a minor slump to around $3 billion. Last year the Sri Lankan stockmarket more than doubled in value, making it one of the best-performing in the world.  Food prices remain punishingly high, yet inflation is down.  The economy is expected to grow by around 6% this year.

Leopard, writing in its latest newsletter, agrees. 

The [election’s] decisive outcome assures policy continuity for the numerous important infrastructure projects underway across Sri Lanka, including deep sea ports, power plants, dams, highways, railroads and airports. Most of these projects are being funded on concessionary terms by external donors such as China, India, Japan, and the ADB, providing billions of dollars of assistance for a country of just 20 million people.

Unnoticed by most global investors, this mini “Marshall Plan” will turbo-charge Sri Lanka’s economic efficiency and productivity, powering top-quartile economic growth for the next couple decades. Other domestic growth catalysts include the reintegration of the cut-off North and East provinces into the national economy, the return of tourists, the sharp decline of local interest rates and the reawakening of Sri Lanka’s hibernating capital markets. A massive private investment cycle is gathering force as business confidence ratchets higher and boardroom priorities shift from controlling costs to capturing fresh opportunities. We encourage you all to visit Colombo and sense the local optimism first-hand; it may be Winter in the West but it is Spring in Sri Lanka.

Long-term, two seemingly perpetual problems remain, however, which investors should factor in to whatever return they might seek on any capital they may invest.  One, the ethnic divisions between Tamils and Sinhalese remain.  Two, executive power remains separate from parliament and should (arguably) be returned, an outcome that rests on Mr. Rajapaksa’s desire to subvert his own power.  To that extent, future division between political and ethnic parties may well reside on the strength and relevance of a main opposition party, which in and of itself will likely be a factor of how well Tamil and Muslim factions can negotiate and compromise.  That said, there is little standing in the way of short term market acceleration, especially with a central bank committed to facilitating the President’s desire to see 7% growth in 2010.   The country’s exports rose 6.4% in December to $723.4 million after a yearlong decline, while the central bank kept key benchmark rates unchanged and at a five-year low.

Douglas Clayton’s Leopard Capital, which last year launched Cambodia’s first multi-sector investment fund, announced the launch of a Leopard Sri Lanka Fund LP for early 2010.   “After several decades of civil war, peace has finally returned to the beautiful island of Sri Lanka, and a new investment cycle and growth upswing has begun.  Leopard Sri Lanka Fund will provide expansion capital and strategic guidance to mid-market Sri Lankan companies, and also help some expand their businesses into other frontier economies,” the firm notes.  Leopard Sri Lanka will be headed by Colombo-based managers Nirosh De Silva and Ramanan Govindasamy.

Investor confidence in the island is high, as country visits surged this summer and plans emerged to expand hotel and resort facilities.  Moreover, official reserves surpassed the $4 billion mark in September–roughly equivalent to over 4.4 months of imports–and is Sri Lanka’s highest ever reserves level.  The Central Bank noted that this level should strengthen in coming months on the back of increased foreign exchange inflows.  Finally, the country’s exchange remains up over 40% since the offical cessation of violence in May.

Following the defeat of the Tamil Tigers’ (LTTE) 26-year insurgency in Sri Lanka, the Colombo Stock Exchange (CSE) surged, with the All Shares Price Index (ASPI), which tracks the movement of all the stocks listed in the CSE, recording its sixth highest daily percentage growth in history, and the Milanka Price Index (MPI), composed of 25 select equities, realizing its fifth highest percentage growth in history. Meanwhile, volume during the week reached the four highest number in history. While there was some profit taking on Friday, the ASPI gained 20% for the week (4.21 points) to end at 2,146.73 while the more liquid MPI gained 34% (8.25 points) to close at 2,466.90. Both indices are now up over 35% for the year.

Not surprisingly perhaps, some of the week’s biggest gainers were in tourism, lead by Miramar Beach Hotel (up 33%), Taj Lanka Hotel (22%) and John Keells Hotels (19%). The biggest gaining sector was the diversified one, lead by John Keells, which deals in ports, tourism, retail, food and beverages, financial services and property and is considered by analysts as a proxy for investment in the country, per news reports. Despite the profit taking on Friday, Geeth Balasuriya, research manager at Acuity Stockbrokers, doesn’t see the upward market trend abating quite so quickly. “We expect the positive sentiment to continue into the short to medium term,” he surmised.

Sri Lanka, for various reasons, is an overlooked market, but given civil stability that should quickly change. Its population roughly equals that of Australia, for example, and per capita income is nearly double that of India. Billions of dollars spent containing the LTTE can now be funneled for other purposes, pundits note, and rebuilding the nation’s infrastructure should be on top of the list. IMF funds and those from the Tamil diaspora must also be taken into account, and firms in India will likely receive the bulk of any contract work. Additionally, tourism to the island can be expected to explode, especially given some 350 sq km of beaches and hill stations, cities and historic sites. Finally, a hitherto underutilized port–the port of Trincomalee, which lies on the main shipping lanes–can be used to complement Colombo, observers say, and also compete with Indian ports.

Sri Lanka saw a 24% surge in Middle East tourists in 2008, according to figures released by the Sri Lankan Tourist Promotions Bureau (SLTB).  The country saw the strongest increase in UAE, Kuwait, Qatar, Bahrain, Lebanon and Iranian visitors–making the Middle East the fastest growing source market for the country.  “Sri Lanka’s tourism industry is anticipated to make rapid strides, owing to increased travels related to wellness and spas, culture and adventure purposes,” according to Heba Al Ghais Al Mansoori, the Middle East director of SLTPB.  “Declining costs of travel, changing lifestyle patterns, consumer friendly travel facilities, and good child care and maid facilities for Arabs travelling with families have been key growth drivers.”

At the same time, hotel revenue per available room (RevPAR) in Dubai dropped by 25.9% in December, compared to the same period in 2007, as visitors to the emirate declined as a result of the global downturn.  “Middle Eastern cities had similar variations in RevPAR performance showing that the region is not immune to the global economic woes.  The meltdown’s impact on the Middle East was somewhat delayed as illustrated by the figures for the change in monthly RevPAR over the final quarter of 2008,” according to research firm STA Global.

That said, RevPAR in Abu Dhabi increased by 8.9% in December.

Bloomberg report from last week stating that Sri Lanka’s government will start its first overseas bond sale, testing investor appetite for emerging-market debt following a global credit-market slump. The catch? “Fitch Ratings gave Sri Lanka a negative outlook in 2006 because of the violence, meaning it is more inclined to reduce the credit ranking. Borrowing costs have surged. The yield on the government 7.6 percent local-currency bond due in August 2009 climbed to 16.2 percent from 11.469 percent a year ago.”

Sri Lanka’s stock exchange has lost around 10 percent of its value since early August, the impact of seemingly eternal war with the rebel Liberation Tigers of Tamil Eelam, combining with local and global economic issues. An article in this week’s Economist (“Whose Victory?”) hints at the war’s end, as the Sri Lankan army continues it surge north. Fighting has escalated in recent months in the 25-year-old civil war, as the military has captured a series of rebel bases and large chunks of territory in the north. State officials have pledged to crush the guerrillas by the end of the year.

Yet many pundits and observers wonder what difference any cessation in violence (aside from the obvious curtailment of human rights abuses and deaths, presumably) will actually make, especially if the root causes of the conflict are not addressed.

One letter writer may have summed up the matter quite well:

Victory for the armed forces or defeat for the LTTE? It does not matter – as the underlying problem has nothing to do with the war rather with the discovery of a comprehensive political solution for not just the ethnic imbalances but for the tremendous socio-political inequities that pervade the Sri Lankan system . . . Regrettably, instead of discovering egalitarian solutions to these fundamental challenges, Sri Lankans have elected to fight among themselves (i.e. Rajapaksa vs Prahabakaran) in the futile hope that a victory or a loss will somehow, magically, yield solutions. It won’t – the simple fact is there are no victors in this grave human tragedy.

Geopolitics aside, some economists remain somewhat bullish on the local economy.

Chief Economist Dr. Yeah Kim Leng of RAM Ratings (Lanka) Ltd. (f/k/a Lanka Rating Agency (LRA)) remarked this past March, for example, that especially given the country’s protracted civil war, its growth numbers were commendable.

“More recently in the past five years Sri Lanka has achieved a growth of 6.2% per annum compared to Malaysia which achieved a growth of 5.8% and in real terms Sri Lanka’s economy is growing at a higher rate compared to Malaysia although the base is lower which is the main difference.

The income levels in Sri Lanka are lower than Malaysia. The average per capita income is about US$1500 in Sri Lanka while it is US$5000 in Malaysia. But in growth rates Sri Lanka is growing much higher than Malaysia. This is where you can attract more investments because Sri Lanka is able to achieve sustained growth at moderately high levels and we are quite positive about the potential.

The growth is now driven by domestic demand and consumer spending is growing at 4.8% per annum. It is moderately strong. More interesting is that private investment has been growing at double digit averaging 12% for the last five years. Private investment can be sustained and will continue to be sustained medium to long term growth potential for Sri Lanka and this is where the corporate bond market comes in to finance the growth.

Kim Leng also commented on the situation of the bond market in Sri Lanka:

The government bond market is fairly large while the corporate bond market is fairly small with Rs 2.2b being raised last year. Since the corporate bond market is small we think that there is potential for growth as the infrastructure investment has to be funded. US$4.5b is needed as infrastructure. How is this going to be funded? A part will be funded by the international agencies while the balance can be funded by the corporate bond market. It will become very efficient.

In the 1980’s the savings rate was 15% while in the 1990’s it was close to 20% and more recently it has risen to 23-24% and that is mainly because of the growth in the banking sector which has to mobilize more savings. In all developed countries there is a strong banking sector and a deep capital market. In Sri Lanka the bond market is missing. If this can be developed the national savings rate can increase at a fast rate and the savings investment gap which at present stands at 3.2% . The bond market can help to raise investment levels to a much higher level which is currently hovering around 26-28%.

JGW

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