Now that Sri Lanka’s civil war is over and the Tamil Tigers’ leaders have been eliminated, President Percy Mahinda Rajapaksa will have to turn his attention to winning the peace. This may actually be harder than winning the war. For a start, the government will need to reintegrate the Tamil minority – of which more than 20,000 civilians may have been killed in the final phase of the war – and re-house hundreds of thousands of displaced people. But even excluding the war’s aftermath, Sri Lanka has been grappling with some of the most severe economic imbalances of any economy in Asia.

• Firstly, Sri Lanka’s budget deficit has been above 7% of GDP for most of its post-independence history. Anyone doubting the sustainability of widening budget deficits in the Western world would be advised to look at Sri Lanka for proof that this is possible. But this requires more foreign financing.

• Secondly, Sri Lanka maintains severe trade and current account deficits (exacerbated by high oil prices in recent years) which look set to persist for many years to come. These deficits make it difficult to stabilise the Sri Lankan rupee (LKR), which has been depreciating steadily for many years.

• Thirdly, while Sri Lanka has seen its inflation fall from a record high of 28% last year, it remains very high – 14.7% on a 12-month moving average basis – by Asian standards. This is a reflection of a combination of printing money to finance the deficit (including higher defence spending in recent years) and the oil import factor.

As a result of the above, and because of rising risk aversion late last year as the global economy went into meltdown, Sri Lanka only narrowly avoided a balance of payments crisis, and only thanks to promises of a US$1.9 billion IMF loan. At one stage, Sri Lanka’s foreign reserves had fallen to around US$1 billion, or less than a month’s worth of imports (three months’ worth is generally considered the critical level). But the IMF loan is not yet home, with the US seemingly delaying its disbursal due to outrage over civilian deaths in the final phase of the war.

Signs Of Stability Emerging
Nonetheless, there have been positive signs in Sri Lanka’s financial markets of late, suggesting renewed investor confidence.

The rupee has stabilised at LKR114.80/US$ after hitting a record low of LKR120.80/US$ in late April. As the chart below shows, it has returned to a long-term depreciation channel. It might even rise to the upper (i.e. stronger) range of this channel if long-awaited donor aid pours in.

The Colombo Stock Exchange (CSE) index has also rallied sharply (by around 37%) over the past two months, as seen in the chart below. That said, I am not convinced that this is entirely based on peace dividend hopes. Indeed, the CSE’s 37% gain is more or less in line with other Asian equity rallies over the same period, and global equities look strong in general. In fact, the CSE has underperformed many stock markets in Asia and globally.

Going forward, it is difficult to say how durable the CSE’s rally will prove. As the chart shows, the index surged by more than 400% from 2002 – when a ceasefire between the government and Tamil Tigers was signed – to a peak of more than 3,000 points in 2007. Significantly, the rally continued even after the ceasefire broke down in 2006, although the CSE later stabilised at 2,500 points. However, keep in mind that the 2002-07 rally coincided with a period of strong global economic growth, which also benefited Sri Lanka. This time round, the global economic outlook is bleak, and although Sri Lanka is less dependent on external trade than many Asian nations, it will still struggle to achieve 3% growth this year.

Then there is the question of when tourists will return. Tourism is a major earner of foreign exchange (although behind tea and remittances) and indirectly assists other sectors of the economy. Visitor numbers understandably plummeted as the civil war intensified in 2007-09 (the surge in the chart in late 2007 reflected a major cricket event, and is thus an aberration). Yet Sri Lanka has a rich cultural heritage, and in fact two couples I know honeymooned there in 2004-05. Film buffs will also know that Indiana Jones And The Temple of Doom was filmed there, for its exotic scenery. Nonetheless, the association of war and death, combined with the global recession, leads me to believe that a tourist boom is not imminent.

‘Strategic Importance’
Over the long term, Sri Lanka – or at least Colombo – hopes to become the ‘Singapore of South Asia’, counting on its strategic location astride the crucial east-west sea lanes linking Europe and the Middle East with the rising economies East Asia. Indeed, China, India, Japan and even Iran are all bidding for influence there, with Beijing viewing the island as a possible pearl in a ‘string of pearl’ network of regional naval facilities. As geopolitical competition in the Indian Ocean increases, Sri Lanka will in my opinion probably seek to maximise economic assistance from the Great Powers.

But that may not be enough. There are many ‘strategically important’ countries that receive foreign aid and investment yet remain underdeveloped. President Rajapaksa will need to do a lot more to improve governance and create an environment more conducive to foreign investment. His nationalist administration has been less business-friendly than its predecessor, and this could stunt Sri Lanka’s recovery.

Tags: budget deficit, economic prospects, financial crisis, IMF, peace dividend, rupee, Sri Lanka, stock market
Posted in: Asia, Currencies, Equities, General, Geopolitics, Political Risk
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