Economic Outlook: A tough year ahead but measures in right direction

Broking firm Arrenga Capital Ltd., has come up with an analysis on the outlook for Sri Lankan economy capturing some of recent developments and their implications. Here are excerpts
Economic Summary: Delayed decision to curb excessive credit growth

Sri Lanka’s excessive credit growth experienced in the 2H2011 coupled unsustainable rupee peg was leading the country to a fresh Balance of Payments crisis forcing the Government and the Central Bank to unpopular policy decisions to slow down economic growth and address the balance of payments situation which is required for long sustainable economic growth. The major policy developments included;

• Hike in government policy rates
• Allowing flexible exchange rates
• Sharp upward revision of fuel and electricity prices
• Imposition of a maximum limit for loan book growth of Commercial Banks for 2012
• Increase of import duty on motor vehicles
• Direction to limit credit for purchase of motor vehicles

The above decisions have resulted in a sharp rise in interest rates gradually improving liquidity in the system and decelerating demand for credit. The imports are likely to show steep decline in the short to medium term with the depreciation of the rupee and the decline in purchasing power of consumers leading to an improved balance of payments position. The approved IMF funds are likely to bring back confidence to the investors and stabilize the exchange rate.
With these measures economic growth is likely to slow down during the next 6 months while a recovery of economic activity is expected beyond August 2012.
Economy overheating amidst a sharp rise in credit growth
Year 2012 initiated with the GoSL implementing several controversial regulatory measures aimed at addressing a number of serious macroeconomic issues which were imposing considerable threat to the sustainability of healthy growth in the economy. The policy measures were taken aftermath of a year of high growth in the economy (8.3% YoY Growth in GDP during 2011), where private sector credit growth exceeded original estimates by far, growing by nearly 34% YoY. The excessive credit growth was observed with trade related credit and credit driven by import related items such as motor vehicles & consumer durables growing substantially, whilst credit extended to government and public institutions had also escalated.
The high credit growth was reasoned by several factors including low interest rates, import duty reductions (GoSL Budget 2010) & increasing disposable income in the economy, whereas credit to government magnified amidst a soft dollar peg. At the meantime, the credit to export related activity had grown by only 8% YoY during 2011.
Amidst excessive domestic credit growth, the country’s import expenditure grew by 50.4% YoY to USD20.2bn during 2011, with imports of investment goods, petroleum & consumer goods escalating by 60.3%, 53.4% & 83.3% YoY respectively.
Meanwhile, the export income of the economy grew by only 22.4% YoY amidst challenging global demand conditions. Thus, the country’s trade deficit widened to USD9.7 bn by end 2011. Nevertheless, the worker remittances grew by a steady 25% YoY to USD5.1 bn during 2011 providing some cushion to the worsening foreign reserve condition in the economy.
IMF pulls out as Central Bank defends a currency peg
Following the greenback sales by the CBSL to defend a currency peg and a rapid escalation in the import expenditure, the country’s foreign reserves fell sharply to USD5.9 bn by end 2011, from a high of USD8bn by end July 2011 following the sovereign dollar bond sale by GoSL.
This inevitably prompted regulatory action amidst IMF calls for higher domestic interest rates and to float the currency to avoid a possible fresh BOP crisis. The tight financial market conditions were clearly reflected from the deteriorating liquidity position in the banking system, where the excess liquidity stood at LKR10 bn by end 2011 as opposed to LKR124 bn as of end 2010. The pressure on the economy kept creeping up amidst the above developments, which was worsened by the IMF’s decision to hold back the final two tranches of its USD2.6 bn bailout facility until the GoSL limit its forex interventions and take necessary steps to avoid a fresh BOP crisis.
Corrective measures to address Balance of Payments position
Consequent to the above issues, GoSL and the Central Bank implemented several serious measures which despite being subject to heavy criticism over a short term were necessary steps to ensure sustainable growth in the economy. These major policy developments included;

• Hike in government policy rates to curb credit growth
• Allowing flexible exchange rates to improve external finances
• A sharp upward revision of fuel and electricity prices to match rise in global prices and reduce losses of the state entity
• Imposition of a maximum limit on bank credit growth numbers for 2012
• Increasing import duty on motor vehicles
• Direction to Commercial Banks to limit credit for purchase of motor vehicles

The combined impact of all the above measures would inevitably lead to a slowdown in the economic growth for 2012, thus the GDP growth forecast for 2012 was downgraded by the CBSL to 7.2% from an original estimate of 8%. The inflationary pressure which has been well controlled over the recent months is likely to witness some adverse effect over the next few months, particularly with the festive season also falling in. This was already evident as the country’s YoY inflation measured by CCPI increased to 5.5% during March 2012 from a 2.7% in February. This is likely to escalate further over the upcoming months with higher domestic interest rates, rupee depreciation and the government’s decision to increase taxes.
On a conclusive note, we expect year 2012 to be bring about a series of changes as the economy focus on combating inflation and adjust itself for a period of slower growth. The higher interest rates & taxes would slow the credit growth in the economy. The rupee depreciation and expected slowdown in consumption driven imports are likely to improve the external finances over the medium term. The overall recovery of the economic growth would depend on how fast businesses adjust themselves for the changing conditions and return towards another pace of high growth.
Equity market outlook
Bleak short term but bright long term prospects
The recent policy measures introduced by the GoSL and the Central Bank provide a weak outlook for Sri Lankan Equities. The rise in interest rates provides an incentive to investors with a low risk appetite to shift their investment funds towards fixed income signalling selling pressure likely to be created with the market itself.
The rise in fuel, electricity prices and increased taxes on motor vehicles are likely slowdown economic growth resulting in lower consumer demand and higher savings. Profit growth in most segments are downgraded as market earnings are likely to grow by only 7-8% for the financial year ending Dec 2012E / March 2013E. While most sectors are likely to record lower growth rates, sectors such as finance, leasing and motor sector may record declines in their profitability.
We expect economic conditions and earnings of most companies to start improving towards August representing 3Q-4QCY12 resulting in a better second half for most companies with the expected improvement in economic conditions. As a result long term valuations of the market seem attractive with the tough policy decisions already implemented in the 1HCY12.
Market valuations attracting foreign inflow
The Colombo Stock Exchange being crowned as the ‘Asia Best Performer’ during 2010 with a massive 96% YTD return, saw a reversal in trend during 2011 amidst an inevitable correction following a run which led the indices to exaggerate to highly unjustifiable levels. Hence, the benchmark index, having touched a peak of 7,800 points during February 2012, now trades at 5,400 levels indicating a mammoth 37% correction. Following the deep correction observed during 2011, the market entered a reasonable valuation platform as the market trailing PER dropped to around 10x (as opposed to +20x during its peak).
The overall corporate earnings were also encouraging as the market earnings grew by c.123% YoY for the financial year ended Dec 2010/Mar 2011. Earnings for the financial year ended Dec 2011/Mar 2012E is likely to reach c.14% YoY despite the final quarter of March year end companies affected by the recent policy changes.
As market valuations returned to attractive levels foreign investor interest was seeing gradually gathering momentum as the YTD net foreign inflow topped LKR20 bn compared with an outflow of LKR19 bn recorded during 2011.
Delayed policy measures affects short to medium term prospects
However, as discussed above several policy mismatches in the economy (CBSL’s effort to control both the interest rate & the exchange rate simultaneously), led to an increasing threat of possible fresh BOP crisis. Despite being rather late, GoSL introduced a number of remedial measures as discussed above, which is expected to slow down the growth of the economy during 2012.
The rising domestic interest rates are likely to lead the investors to pull their investments out of the risky assets and invest in risk free instruments such as government securities over the short to medium term. Furthermore, the devaluation of rupee would immediately reduce the foreign portfolio values, albeit would encourage fresh foreign funds due to each stock now being cheaper for the foreign investors.
The above developments are likely to hamper the short term prospects of the Sri Lankan equity as the prevalent uncertainty would lower the overall confidence level in the market, whilst a slowdown in market earnings growth would limit the overall upward potential in indices in the short term.
Attractive long term prospects
Nevertheless, we expect the current volatility particularly in interest rates & exchange rates to mild down towards the 2H2012, thus bringing some stability. We believe that the local companies would take some time to re-adjust themselves to the increased cost structure while domestic demand would also suffer in the short term and likely to improve towards August 2012.
We believe most companies are likely to provide improved earnings towards the 2nd half of the current financial year (FY13) while growth rates in company earnings for Dec 2013 / Mar 2014 is likely to improve to 16-18%. Our market valuations are approximately 10.8x FY13E earnings while trading at 9.3x FY14E earnings.