Sri Lanka Economics: External sector - Challenging but stable; concerns overdone

Sri Lanka Economics: External sector Sri Lanka's future prosperity largely depends on its fast growing and innovative exports sector. The government policies are aimed at developing Sri Lanka as a trading hub on the East-West route; perhaps in direct competition with Singapore and Hong Kong. Even though economic recovery in most developed markets like the US and EU has been sluggish, leading to lower consumption demand, Sri Lanka's exports have increased substantially since 2010. The Sri Lankan government has set an ambitious target of achieving US$ 15bn worth annual exports by 2015. Although it may seem an uphill task, we believe that it is certainly achievable through diversification of product mix and also the destination. In the short term, the renewed concerns on a double dip in western economies may result in a moderation in exports. However, recent concerns over debt sustainability and risks to balance of payments are overdone, as are the central bank's intervention in the currency markets. Our 2011/2012 export forecast remains at US$ 9.4bn/11.1bn respectively. Ambitious exports targets: The total value of exports has increased from US$ 7.1bn in 2009 to US$ 8.3bn in 2010. The Sri Lankan government has set an ambitious target of achieving US$ 15bn worth annual exports by 2015 and US$ 20bn by 2020. We believe that these targets can be achieved by diversifying and expanding the destination and broad basing the export products avoiding over dependence on a few basic products. Foreign trade drivers: The government's policy document, Mahinda Chintana, envisages Sri Lanka to be transformed, as a strategically important economic centre of the world. In this transformation, Sri Lanka will be developed into a trading hub providing links between the East and the West. The Hambantota port project is expected to provide world class infrastructure for manufacturing as well as cargo projects. There is constant urge to move from the exports of agriculture and apparel products to more sophisticated manufactured products. The 2011 budget focuses on development of export oriented manufacturing units. It has reduced duties and taxes on machinery, equipment and raw material to enable enterprises to have affordable access to world class technology, and also proposed to lower income tax from 15% to 10% for industries with domestic value addition in excess of 65 percent. The Export Development Board (EDB) has also focused its attention on the service sectors such as cargo handling and information technology services as means to increase the revenue. Geographical diversification is the key: The United States and Europe have been the major trading partners for Sri Lanka for years, cumulatively accounting for about 65-70% of the country's exports. The apparels made for designer labels like Victoria's Secret, Liz Claiborne and Tommy Hilfiger etc. account for about 40% of the country's exports, while tea exports account for another 20-25% of the total exports (see table on page3). Sri Lanka's exports were hit very hard during the global economic downturn. The industry is still smarting from the slump in demand but the recent move to diversify to emerging Asian economies - China and India - should keep the exports growth momentum intact. GSP scheme extended until 2013: Since 1971, the EU has had rules ensuring that exporters from developing countries pay lower duties on their exports. This gives them vital access to EU markets contributing to the growth of smaller economies. This scheme, known as the "Generalised System of Preferences", has now been extended for Sri Lanka until 2013. This scheme provides access to 7,200 Sri Lankan products at zero duty into the European Union. Rupee dilemma: Sri Lanka's dilemma is that making exports more competitive (cheaper) by weakening the rupee also makes the cost of imports, including food and fuel, expensive – stoking inflation. In the recent past, Sri Lankan Rupee has been gradually appreciating vis-a-vis major foreign currencies mainly due to US dollar losing its value steadily in the international financial markets. The exporters were not generating enough revenue to make the government prioritise them over keeping imports cheap. A stronger currency helps in easing the cost of living in this import-dependent economy. Concerns overdone: Of late, because of the renewed uncertainty in global financial markets and the risk of another global recession increasing, 'safe haven' argument has made investors flocking to dollar, leading to it appreciation. However, with appreciating foreign currency, the country's debt has increased, raising questions on the debt sustainability of the economy, if the trend continues. After falling provisionally to 82% in 2010, the debt to GDP ratio is expected to decline further to 80% in 2011. Foreign debt has accounted for a little below half of the total debt over the last few years. We believe that the rupee weakening pressure on Rupee is at best a very short term trend, and the concerns on the balance of payments and debt sustainability or even central bank intervention in currency market is overdone. Intervention necessary: The CBSL has often intervened on both sides of the market to maintain stability while also allowing adequate flexibility. The IMF has repeatedly asked the CBSL to limit currency intervention and allow more flexibility in the exchange rates. However, we believe that intervention may be necessary for an economy to avoid excess volatility in the currency, as the economy is largely import dependent for manufactured products and is also aiming at developing itself into a major global trading hub because of its strategic geographical location. Identification of key sectors: The first step in developing a strategy aimed at scaling the export targets should involve identification of key sectors. As seen in Fig. 2, we believe that the current export policies should be aimed at maximising potential in Apparels, Tea and Rubber products sectors. These sectors form a large part of the country's exports and are likely to continue with the growth momentum over the next five years. At the same time, in line with government's policy of moving to sophisticated manufactured exports, we believe that special incentives should be provided to Chemical products, Information Technology and Electrical sectors. Future outlook: The high energy cost - electricity tariffs in the country being one of the highest in south Asia – reduces the global competitiveness of Sri Lankan exporters. The stronger rupee has made it even more difficult to survive in the global export market. The persistent congestion at Sri Lanka's major ports result in shipping delays; which are likely to reduce when Hambantota port becomes fully operational. Resolution to such basic issues along with government export incentives in the form of lower duties, are likely to further boost exports over the next decade. In the short term, the renewed concerns on a double dip in western economies may result in a slowdown in exports. Our 2011/2012 export forecast remains at US$ 9.4bn/11.1bn respectively. To see the full version of this report with exhibits, please click here  or see the attached report.

Thanks and Regards Jay Shankar | Chief Economist - Director, Religare Capital Markets Limited,  3rd Floor, ING House, G Block, Bandra Kurla Complex, Mumbai 400051, India