Sri Lanka: Location, Location, Location August 2017
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SRI LANKA: LOCATION, LOCATION, LOCATION AUGUST 2017 While it is easy for investors to overlook Sri Lanka due its close proximity to larger and highly-populous neighbour India, we believe there is significant untapped potential in this frontier economy. We found plenty of promise during a recent research trip to the diverse Asian country – in particular its strategic Indian Ocean location. THE QUAYS TO SUCCESS Oliver Bell Situated in the more-stable centre of the often-volatile Indo-Australian tectonic Portfolio Manager, plate, Sri Lanka’s shoreline, unlike India, is fortunate to be largely surrounded by Frontier Markets Equity Strategy deep water – the required ingredient needed to house large-scale port developments. Sri Lanka has three main ports – on its east, west and south coasts – which are perfectly situated along the main shipping route between Asia and Europe. Colombo, the Sri Lankan commercial capital, is home to the country’s largest port – which currently has three major associated quays. These quays are each owned by the Sri Lankan government, the Chinese, as well as John Keells Holdings – Sri Lanka’s largest listed conglomerate. An additional two quays for the Colombo port are likely to be constructed in the near future – which will find no shortage of “Sri Lanka has suitors, particularly from India. China is well aware of Sri Lanka’s strategic location and has invested heavily in the country over recent years. Despite some setbacks three main ports – largely related to India’s fears over Chinese military influence in the area – Sri which are Lanka late last month finally signed its long-awaited US$1.1bn deal with China for development and control of the southern port of Hambantota. This project forms perfectly part of China’s giant trillion-dollar ‘One Belt, One Road’ initiative. situated along We believe Sri Lanka could witness a multi-year construction boom. In addition to the main the resumption of China-led developments, there are a number of other large-scale shipping route public and private projects in the pipeline. Tokyo Cement is the largest cement manufacturer and supplier in Sri Lanka. The group has a 32% market share in the between Asia country and has recently increased its capacity by 1m tonnes to 2.8m. and Europe.” FOR INVESTMENT PROFESSIONALS ONLY. NOT FOR FURTHER DISTRIBUTION. “After almost three years of government inactivity, we are finally witnessing positive momentum in Sri Lanka’s reform agenda.” POSITIVE PATHS OF REFORM This capacity increase will displace imported cement. Access Engineering is another direct beneficiary of Sri Lanka’s medium-term infrastructure development plans – with the company involved in projects across numerous sectors. While Access has been growing its order book by 20% a year, the group could have the ability to grow even faster, but has been prudently selective with its projects. After almost three years of government inactivity, we are finally witnessing positive momentum in Sri Lanka’s reform agenda. We believe these reforms have the ability to further accelerate economic growth in Sri Lanka, a country already fortunate to boast a highly-educated workforce and a growing number of international tourists. Recent market-friendly government action includes the naming of a new finance minister – among other top-level ministerial changes – as well a new central bank governor. We were fortunate to have dinner with the new governor, who articulated to us the substantial reforms in the pipeline. Another positive development has been the establishment of a new five-person working group, including the aforementioned minister of finance and central bank governor and two other economic ministers, one of whom we also met on this trip, which sits with President Maithripala Sirisena each week to push forward the reform agenda. Key recent initiatives include plans to broaden the tax take – which currently sits at a low 15% of GDP – as well as the implementation of a fairer tax structure and the ending of subsidies. ACCELERATION OF GROWTH Sri Lankan GDP growth is expected to come in at about 4.5-5% this year, a slightly softer number than previously expected due to a spate of recent natural disasters – namely floods and drought. However, the aforementioned economic reforms – as well as the current IMF loan programme, renewed infrastructure investment and the recent resumption of European Union GSP+ duty-free concessions – are expected to drive GDP growth upwards in 2018 and 2019. As for monetary policy, the Central Bank of Sri Lanka is now the end of its benign hiking cycle, with interest rates tightened to control credit expansion, which hit 28% at its peak. The tightening has successfully brought inflation down to about 5%, within the 4-6% target range. Rates are expected to stabilise at this level and, subject to credit growth remaining under control, a loosening of policy could be on the cards over the next 18 months. In terms of currency, while central bank intervention has been substantially reduced, a fully floating currency is unlikely to be in place until 2019. The Sri Lankan rupee is currently deemed to be only about 6% overvalued, but the authorities plan to allow it to continue adjusting on a gradual basis and only intervening to smooth the volatility. Despite the tighter monetary conditions, we believe the strong-growing Sri Lankan bank sector is cheap relative to historic price-to-book levels and is currently displaying solid growth. The sector is likely to receive a further boost over the medium-term as the rate hike cycle has now likely concluded. Hatton National Bank expects to deliver loan growth of 15% in 2017, rising to 20% over the next two-to-three years on stronger economic growth in the country. Its non-performing asset levels have fallen from 4% in 2013 to just 1.8% last year, primarily due to the centralisation of credit origination and underwriting. As for the Commercial Bank of Ceylon, it expects to see loan growth of about 17% this year, a level it sees as sustainable over the next three years. COMFORTABLE BEING EARLY We remain convinced Sri Lanka, one of the largest active positions in our T. Rowe Price Frontier Markets Equity strategy, is an attractive multi-year investment opportunity. While there is a danger we might be too early, our thesis is predicated on continued positive government reforms and we were impressed by what we witnessed during our recent visit. 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