Sri Lanka Stocks: Reaping The Peace Dividend
I’ve long been a keen observer of ‘Frontier Markets’, that is, markets which are considered too risky for most investors, due to their political instability or economic mismanagement/vulnerability. However, these markets sometimes provide the best returns. A case in point is Sri Lanka, whose Colombo Stock Exchange (CSE) index has emerged as the best-performing stock market in Asia in 2009 and the second-best global performer after Peru, with gains of 108% year-to-date.
The index has seen a particularly sharp increase since May, when the Liberation Tigers of Tamil Eelam (LTTE, ‘Tamil Tigers’) officially conceded defeat, bringing the country’s 26-year civil war to a close. However, foreign investors have largely remained on the sidelines, begging the question of whether they have missed the party. Here are my thoughts:
Inevitably after such steep gains, I’d be wary of expecting too much more upside. Although the ceasefire signed between the government and LTTE in early 2002 led to a massive five-year rally that caused equities to rise more than five-fold to a then-record high of 3,000 points in 2007, we have witnessed a much steeper rally this time round, with the index at a new peak of 3,130. Also, the period 2003-07 was a time of very strong global economic growth that buoyed Sri Lanka, which exports mainly to the US and EU. This time round, the global economy in 2009-13 is expected to be much weaker than 2003-07 as worldwide imbalances are smoothed out, and this could constrain Sri Lanka’s economy.
Positive Factors For Sri Lanka
- Sri Lanka’s economy should still outperform many others, thanks to a very high proportion of GDP (more than 75%) derived from private consumption, and ongoing efforts to rebuild the previously LTTE-held areas. Business Monitor International (BMI) forecasts 3.3% real GDP growth in 2009 and 4.4% in 2010, which is better than most countries.
- Also positive is that Sri Lanka has avoided a total financial crisis thanks to a US$2.6bn IMF loan. This is a major relief for the government, because earlier this year the country was on the brink of a balance of payments crisis. Indeed, the government’s final military offensive against the LTTE led to international concerns about human rights violations, which delayed the disbursal of foreign assistance.
- The domestic political situation also appears to be improving. President Mahinda Rajapaksa’s United People’s Freedom Alliance (UPFA) won a strong victory in last weekend’s provincial elections, and he is likely to take advantage of his high victory-driven popularity by calling an early presidential election in January 2010 (well before this is due in November 2011), ahead of parliamentary elections due by next April. A re-elected Rajapaksa with greater support in the legislature would allow him to ditch his Marxist and hyper-nationalist coalition partners.
- Beyond near-term considerations, Sri Lanka is increasingly being courted by China as a strategic ally, with Beijing apparently seeking to make greater use of the island’s ports as its shores up its position in the Indian Ocean basin. While Colombo’s vision to turn Sri Lanka into a ‘new Singapore’ sounds a bit too grandiose, Chinese aid and investment will continue to be supportive.
Possible Risks For Sri Lanka
- Even if Rajapaksa scores resounding election victories, he is not exactly an economic reformer. He has opposed privatisation and the business environment remains hobbled by high corporate taxes, bureaucracy, and corruption. His administration will need to tackle these if Sri Lanka is to attract substantial foreign investment.
- The government will also need to reduce the chronically massive fiscal deficit, which has been running above 8% of GDP for much of the country’s post-independence history. One condition of the IMF loan is to cut the deficit to 5.0% of GDP in 2011, but I cannot help but be a bit sceptical. Oddly, despite the conclusion of the civil war, parliament has agreed to the government’s request for a big increase in its defence budget, which if implemented would clash with the deficit reduction programme.
- Furthermore, it is possible that Rajapaksa has not felt the full wrath of the ‘international community’ over his war record. Thousands of civilians died, and hundreds of thousands became refugees. The US State Department is preparing a war crimes report, and the EU is examining Sri Lanka’s human rights record as it considers whether to renew special trade preferences for the island’s important textile sector.
