A JKSB Research Publication Economic Update GDP % Quarterly GDP Growth 1Q CY04-1Q CY06 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 1QCY2004 2QCY2004 3Q CY2004 4Q CY2004 1Q CY2005 2Q CY2005 3Q CY2005 4Q CY2005 1Q CY2006 2Q CY2006 The economy accelerated in the 1Q CY06 with an 8.3% growth, albeit off a compressed tsunami affected base in 1Q CY05. The sectors most affected by the tsunami were Fisheries and Tourism. When stripped of the effects on these two sectors, the growth is nevertheless significant at 6.8%. The momentum continued, as anticipated into the 2Q with a growth of 7.6%, on the relatively higher base created off a 6.3% growth in the corresponding period in CY05. Chinthaka Ranasinghe chinthaka@jkstock.keells.com John Keells Stock Brokers (Pvt) Ltd. 130, Glennie Street, Colombo 2, Sri Lanka. Tel: 9411 2421 101-9 (Gen.), 9411 2326 003, 9411 2439 047/8 Fax: 9411 2326 863, 9411 2342 068 www.jksb.keells.lk November 2006 The growth drivers, again, were Services and Utilities, which contributed a combined 67% to growth. Telecommunications (17.4%), Electricity (18.4%), Financial Services (8.6%) continued to lead the way, with the Construction Sector (8.5%) and a resurgent Agriculture Sector with growth from a higher Maha paddy harvest and coconut output and a recovering Fisheries Sector adding muscle. The prospects of a return to violence dull the rosy hue the economy has taken thus far. The leisure sector, struggling to recover from the tsunami, will bear the initial brunt along with a moderate loss of agriculture and trade in the affected areas. These are however, smaller sectors of the economy, which, statistically, may be overcome by the addons to GDP of the war effort. The key concerns will be the safety of the economic nurseries of the utilities and the transportation sectors in the Western and Central Provinces, including power generation and the sea and air gateway terminals and the long-term costs of postponed or abandoned investments, be it foreign, private or public. Given the safety of the key economic centers, demand driven telecommunications and utilities expansion will fuel growth, with support coming in from the construction and banking sectors. However, with reversals in tourism trends and stifling economic activity in the affected areas, a drop in the Yala paddy crop coupled with the comparatively higher bases in the latter half of CY05, the momentum is likely 1
to ease off somewhat to 7.2% for the full year of CY06. Several large scale infrastructure development projects await in the pipeline including the Colombo-Matara, Colombo-Katunayake and Colombo Kandy highways, the Colombo South Port and Power Sector capacity additions. The key will be the implementation of such projects, especially those urgently needed in the Power sector. 10.0 % GDP Growth Patterns 8.0 6.0 4.0 2.0 0.0-2.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 1Q 2005 2Q 2005 3Q 2005 4Q 2005 1Q2006 2Q2006 GDP Growth Average The extent and severity of the fresh bout of hostilities will, unfortunately, be the main determinant of the scale of economic growth in the medium term. Whilst short-term targets can be met easily, shifting of attention and resources from value adding sectors to the war effort, weaker investor confidence and a reduction or postponement of economic aid can subdue medium term momentum. However, the Sri Lankan economy maintained an average 4.9% growth during the decades of war, and it is likely that this floor can be somewhat maintained in the case of a protracted war. If not, the medium term prospects can range 8-10%. GDP Growth (%) Sector 2001 2002 2003 2004 2005 2006E 2007E Agriculture -3.0 2.5 1.6-0.9 1.5 3.7 4.1 Mining & Quarrying 0.7 3.0 5.6 7.9 14.1 6.5 5.0 Manufacturing -4.0 1.1 4.2 5.1 6.0 5.7 5.6 Construction 2.5 1.0 5.5 6.6 8.9 8.5 9.0 Services -0.6 6.0 7.9 7.6 6.9 8.6 8.2 GDP Growth -1.4 4.0 6.0 5.3 6.0 7.2 7.1 Fiscal Deficit Focus on tax collections over the last two year paid dividends with tax revenues reversing a negative slope, improving to 14.2% GDP in CY05, from 13.2% in CY03. Whilst current expenditure was pruned from 19.2% GDP to 18.7%, increased capital expenditure, including post Tsunami rebuilding raised total expenditure 24.7% GDP, with the budget deficit expanding to 8.7% GDP in CY05 from 8.2% GDP in the previous year. The approved estimates for CY06 requires a 29% absolute increase in tax revenues to cover an expenditure budget of Rs.731b (an increase of 25%), of which, approximately 7% is Tsunami related expenditure. Revenue has increased by 22% in absolute terms for the first eight months of CY06. Whilst there seems to be continued effort on improving revenue collections, recent legislation seeking to curb alcohol and tobacco usage which are key contributors to the state coffers, may (if successfully implemented) ensure that the government falls well short of its revenue targets. Excluding the effects of 2
such, we expect revenue to come in at Rs.442b or 15.7% GDP in CY06. Expenditure has increased by 27% during the same period this year and is likely to accelerate further with increased defense expenditure from the second half of the year. We see expenditure coming in at Rs.714b in CY06, or 25.3% GDP, with a resultant deficit of 9.7% GDP. It is interesting to note reports of the Auditor General s findings on possible short comings in revenue collection and VAT refunds amounting to over Rs.380b over 4 years, which averages to approximately Rs.95b per year approximating 4% GDP which is the combined collection from Income tax and Excise duties. If such shortfalls can be rectified the country can easily halve its budget deficit or achieve the same deficit despite scrapping income tax altogether, or absorb the war related costs without the imposition of additional levies. However, realistically, if the hostilities extend, the government may resort to further taxing in the form of a defense related levy to bridge the short fall. Government Finance (% of GDP) 2001 2002 2003 2004 2005 2006E Revenue 16.7% 16.5% 15.7% 15.5% 16.1% 15.7% Tax revenue 14.8% 14.0% 13.2% 14.0% 14.3% 14.2% Non tax revenue 1.9% 2.5% 2.5% 1.5% 1.8% 1.6% Total expenditure 27.5% 25.4% 23.7% 23.6% 24.8% 25.4% Current expenditure 21.6% 20.9% 19.0% 19.3% 18.8% 18.5% Current Account deficit -4.9% -4.4% -3.3% -3.9% -2.7% -2.7% Budget deficit -10.8% -8.9% -8.0% -8.2% -8.7% -9.7% Inflation After easing off in the 1Q CY06, cost pressure, predominantly coming through fuel hikes and the consequent roll on effects have seen the CCPI spike up sharply thereafter. However, with crude easing off, administered prices have come down marginally, and further reductions are on the cards, easing pressure somewhat in the final 2 months of the year, despite higher imported inflation created by the sharper drop in the LKR. Averaged, we expect CCPI inflation to come in at 11.5% in CY06. Domestic inflation is predominantly cost pushed. With the currency likely to shed sharper, inflation levels can come in at 8-10% in CY07. Offsetting pressure to an extent will be a reduction of fuel prices, off the sharp increases enacted when crude oil flirted with US $70-75. % CCPI Movement 20 18 16 14 12 10 8 6 4 2 0 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 CCPI Movement Annual Average CCPI Movement Point to Point 3
Interest Rates The Central Bank kept interest rates intact in October 2006, after cumulative hikes of 87.5 bps staggered through September, June and July, leaving the Repo at 9.625% and the Reverse Repo at 11.125%. Since domestic price levels are predominantly cost pushed, policy rates have limited impact on inflation and as such inflation concerns will not necessarily lead to further interest rate hikes. Sri Lanka also has a traditional carry of negative real interest rates on gilt edged and even more on retail interest rates. However, this is of little consolation as rates are likely to be raised gradually to defend the currency, which will be the most pressing worry in CY07, if hostilities continue. External Trade Exports have widened by a healthy 8.9% in the first eight months of CY06. Encouragingly, the export base continues to show evidence of widening, with approximately 58% of growth coming through Food, Petroleum and other Industrial goods, veering away from the traditional dependence on Textile and Garment exports. The contribution from Industrial exports excluding Textiles and Garments increased from 23% in CY00 to 34% in the first eight months of CY06 and that of Textile exports reduced correspondingly from 54% to 44%. Whilst encountering competition from China, the Apparel Sector nevertheless increased export revenues by 4.8% despite the full advantages of the GSP++ benefits not being realized in full by Sri Lankan industry. Composition of Exports Others Mineral Exports Food, Beverage & Other Industrial Exports Textiles & Garments Agricultural Exports 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 2000 2005 Agricultural exports and Non Textile based industrial exports are likely to sustain momentum through the medium term. Exports should grow by 10% in CY06, keeping Apparel exports to a growth of 4.5%. Whilst there is evidence of nontextile based industries expanding to take use of the GSP++ scheme, the key, however, will be how fast the Apparel industry can adjust to the competitive environment. Barring a global economic slowdown or increased freight costs from Colombo on war premiums, exports can sustain 8-10% growth in CY07. Imports grew 21% to end August 2006, under escalating oil prices and a 27% increase in investment goods. Oil prices however have softened from our earlier assumptions of US$ 70 per barrel, easing some of our concerns on a faster rise in import expenditure in the final quarter of the year. Keeping the average crude oil price per barrel at US$65 we expect imports to increase by 17% in CY06. If crude prices remain at the US$ 60 levels, imports can expand by a more sedate 8% in CY07. 4
Summary of External Trade In US$ m 2001 2002 2003 2004 2005 2006E 2007E Agricultural Exports 932 939 965 1,065 1,153 1,265 1,380 Industrial Exports 3,710 3,630 3,977 4,506 4,948 5,458 5,809 Mineral Exports 90 90 84 120 144 149 171 Other 88 41 108 66 102 118 131 Total Exports 4,820 4,700 5,134 5,757 6,347 6,990 7,491 Consumer Good Imports 1,236 1,318 1,480 1,623 1,644 1,840 1,938 Intermediate Good Imports 3,321 3,492 3,812 4,645 5,317 6,100 6,486 Investment Good Imports 1,081 1,164 1,320 1,670 1,869 2,225 2,505 Other 337 125 60 61 33 240 280 Total Imports 5,975 6,099 6,672 7,999 8,863 10,405 11,209 Trade Balance (1,155) (1,399) (1,538) (2,242) (2,516) (3,415) (3,718) Trade Deficit and Balance of Payment The trade deficit expanded by 12.2% to US$ 2516m in CY05, coming under our expectations of US$2,567m with muted import growth compensating for the slower than expected export growth. However, with the acceleration in imports, the deficit has expanded by 52% to US$ 2,400m in first eight months of CY06 and is likely to widen further to US$ 3,415m or 13% GDP by end CY06. Increasing net private remittances and the debt moratorium and Tsunami aid pushed the BOP to a surplus of US$502m in CY05, despite the wider trade gap and a 20% slip in tourism net receipts (approx. US$100m). The inward remittance flow has sustained momentum in the first eight months of CY06, which together with increased tourism receipts and FDI flows have kept the BOP at positive US$ 204m, despite the expanding trade deficit. The remittance flow is likely to sustain if not step up pace, keeping the BOP positive in CY06. The duration of hostilities and crude prices will be critical in CY07. If hostilities continue, delays in rehabilitation aid and FDI s, and a slow down in tourism receipts will combine with a widening trade gap to weigh down on the BOP. The duration of the war will be key to BOP in CY07 even more than crude prices, as a ceasefire and a return to talks can have the reverse positive effects on BOP with potential development aid and a tourism bounce back lending upward support. US$ M External Trade 12000 10000 8000 6000 4000 2000 0-2000 -4000-6000 2000 2001 2002 2003 2004 2005E 2007E 50% 40% 30% 20% 10% 0% -10% -20% Exports (US$ m) (LHS) Trade Balance (US$ m) (LHS) Imports (% of GDP) - (RHS) Imports (US$ m) (LHS) Exports (% of GDP) - (RHS) Trade Balance (% of GDP) - (RHS) Exchange Rate With improving external reserves, the LKR appreciated against most major currencies, gaining 2.5% on the US$, 12.5% against the Sterling and 15% on the Euro in CY05, as indicated by year-end rates. The LKR slid only by a marginal 1.8% against the greenback in the first eight months of CY06. However, as envisaged in our September update, jitters over the escalation of hostilities has resulted in the LKR depreciating by over 2.6% from August to-date, with little intervention from the Central Bank. The pace of the fall however should slacken with the easing of oil prices and we expect to 5
see the LKR end CY06 at approximately Rs.107 against the US$. With oil taking a probable back seat, the focus next year will be the progress of peace talks, upon which defense expenditure and more importantly, aid flows hinge. If the current impasse continues, the LKR can shed a further 5-7% during CY07. 250.00 Rupee External Value Rupee/Unit of Foreign Currency 200.00 150.00 100.00 50.00 0.00 2000 2001 2002 2003 2004 2004 2005 Aug-06 Nov-06 Sterling US $ Euro Summary of Economic Indicators 2001 2002 2003 2004 2005 2006E 2007E GDP GDP at current market Prices (Rs.b) 1409.9 1582.0 1761.0 2029.7 2366.5 2809.0 3308.3 Per Capita GDP at current prices (US$) 841.0 869.9 949.7 1030.9 1197.4 1358.1 1568.7 GDP Growth (%) (1.4) 4.0 6.0 5.3 6.0 7.2 7.1 Population Mid year Population (m) 18.7 19.0 19.2 19.4 19.6 19.8 20.0 Government Finance (% of GDP) Revenue 16.7 16.5 15.7 15.4 16.1 15.7 n/a Expenditure 27.5 25.4 23.7 23.5 24.7 25.4 n/a Current Account Deficit (4.9) (4.4) (3.3) (3.9) (2.7) (2.7) n/a Budget Deficit (10.8) (8.9) (8.0) (8.2) (8.7) (9.7) n/a Interest Rates & Inflation (%) 364 day T-bill (Year end) 13.7 9.9 7.2 7.6 10.3 12.3 13.4 PLR (Year end) 14.3 12.2 9.3 10.2 12.2 14.9 15.9 CCPI ( Annual average) 14.2 9.5 6.3 7.6 11.6 11.5 10.0 External Trade (US $ m) Exports 4820.0 4699.0 5133.0 5757.0 6347.3 6990.0 7491.0 Imports 5980.0 6106.0 6672.0 7999.0 8863.1 10405.4 11209.0 Trade Balance (1160.0) (1407.0) (1539.0) (2242.0) (2515.8) (3415.4) (3718.0) External Reserves ( months of imports) 4.5 4.9 5.8 5.2 5.7 4.8 4.5 Year-end Exchange Rate (LKR/$) 93.2 96.7 96.7 104.6 102.12 107.10 112.50 This document is published by John Keells Stockbrokers (Pvt.) Limited for the exclusive use of their clients. All information has been compiled from available documentation and JKSB s own research material. Whilst all reasonable care has been taken to ensure the accuracy of the contents of this issue, neither JKSB nor 6 its employees can accept responsibility for any decisions made by investors based on information contained herein.