Notable trends seen in Lankan economy in 2013

TOne of the major constraints Sri Lanka faces in attracting (foreign) financial investments is the small size of the economy. The US $ 67 billion economy still falls behind other popular frontier and emerging countries which attract large financial investment inflows

he recently released Central Bank Annual Report for 2013 reveals many economic, social and industry-related trends in Sri Lanka. These trends provide valuable insights for financial investors such as private equity (PE) investors in assessing Sri Lanka’s investment potential. In evaluating these trends, especially macro-economic and social trends, it is often useful to refrain from classifying socio-economic trends as “good” or “bad”, but to analyse the implications of these trends on various industries and businesses as well as for financial investors. Sometimes a commonly perceived unfavourable trend may offer unique opportunities for some businesses. In this brief paper we will briefly look at some macro-economic trends seen in 2013.

Sri Lanka’s GDP per capita doubled in six years

Time taken to double gross domestic product (GDP) per capita is often used to evaluate the potential of a growing economy and the time taken to double GDP per capita declines during periods of rapid economic growth. Sri Lanka’s GDP per capita surpassed US $ 3,000 threshold and reached US $ 3,280 in 2013. It took only six years for GDP per capita to double from 2007 compared to 10 years taken to double GDP per capita in the past (see Table A). The Central Bank forecasts GDP per capita to reach US $ 5,485 in 2017 – a 67 percent growth and it is likely that GDP per capita will double again in five to six years.

Growth in GDP per capita is also supported by gradual decline in population growth and reduction in poverty. Sri Lanka’s population growth reached 0.8 percent in 2013a further decline from 0.9 percent year ago. Poverty also reduced to 6.5 percent in 2012 from 8.9 percent in 2009/10.

One of the major constraints Sri Lanka faces in attracting (foreign) financial investments is the small size of the economy. The US $ 67 billion economy still falls behind other popular frontier and emerging countries which attract large financial investment inflows. As shown above, the time taken to double the size of the economy (in US $) has also reduced to six years from earlier seven years (approximately). Accordingly, it is likely that Sri Lanka will become a US $ 100 billion economy within the next five to six years.

GDP growth driven by job creation and productivity

The Sri Lankan economy grew by 7.3 percent in 2013 compared to 6.3 percent in 2012. What is interesting about the growth in 2013 is that growth was almost equally driven by productivity improvement and job creation. As shown in Table B, 2013 is the first year in post-2009 period where growth was almost equally contributed by both job creation and productivity improvement.

Being a middle income frontier market, Sri Lanka is yet to pass through a phase of industrialization although its service sector has reached 58.1 percent of GDP in 2013 (down from 58.6 percent an year ago). Higher job creation increases household income and higher pro- ductivity helps reduce cost of production – both leading to a more stable and inclusive growth.

Another noteworthy trend is that higher job growth and productivity improvement are also supported by increase in entrepreneurial activities. As shown in Chart A, during last five years, the number of employers and self-employed persons has shown steady increase – this indicates increasing entrepreneurial activities in the economy and even more job creation in the future.

Sharp increase in foreign employment

Sri Lanka’s unemployment rate stood at 4.4 percent in 2013 and has been below 6 percent since 2008. However, when we analyse employment data, we can see that there is a steady increase in foreign employment. In 2013 there was a sharp increase in Sri Lankans leaving for overseas for professional, middle-level and clerical jobs. There is a 61 percent increase in Sri Lankans leaving for professional, middle-level, clerical jobs compared to 11 percent growth in labour categories (skilled, semiskilled and unskilled). Females leaving for domestic jobs have declined by 18 percent (See Table C and Chart B).

Sharp increase in Sri Lankans leaving for professional and middle-level jobs overseas will have some implication on some industries. Increase in Sri Lankans leaving for foreign employment despite economy growing at a faster rate and despite the absence of security-related concerns, suggests emerging economic, social and business phenomena.

As Sri Lankans leaving for foreign employment increase, there is also a trend of increase in foreign nationals working in Sri Lanka. Although there are no official data on the number of foreigners working in Sri Lanka, it was recently revealed that in 2011 alone over 14,000 work visas were issued (to employees from India, China, Korea and UK alone). Many large infrastructure projects funded and/or managed by foreign organisations employ foreign employees. In addition, over 10,000 persons are estimated to be employed in Sri Lanka by obtaining tourist visa.

Both private sector investments and credit decline

Private sector capital formation (investments) grew at a slower space of 11.7 percent in 2013. As shown in Table D private sector investments have slowed down since peaking in 2010 (after the end of the threedecade-old civil conflict in 2009). Private sector investments as a percentage of GDP also declined in 2013 from the recent high of 30.6 percent in 2012. According to economists and policy planners, Sri Lanka needs to achieve investments around 35 percent of GDP to sustain a GDP growth around 8 percent and hence, Sri Lanka clearly lags behind in achieving desired investment level.

In a research article issued by Jupiter Capital Partners (Jupiter) last year, we highlighted that Sri Lankan businesses are over-leveraged and as much as a third of private sector capital formation is funded through (bank) borrowings. We noted how high level of borrowings impacts growth and sustainability of businesses. 2013 saw a reversal of this trend as the private sector credit growth slowed to 8.6 percent despite the easing of interest rates. As a result, the ratio of private sector credit growth to private sector investments also declined sharply to 13.7 percent from 31.7 percent in 2012.

FDIs increase but foreign investment inflows decline

In 2013, foreign direct investments (FDIs) grew at a slower pace of 3.9 percent to reach 2.1 percent of GDP. As shown in Table E, an interesting trend seen in FDI in recent years is the sharp increase in bank loans and retained earnings components in FDI. The equity component of FDI mostly represents investments in new ventures (seed/start-up capital) and is an indication of new entrepreneurial initiatives. In 2013, the equity capital component of FDI was US $ 16 million - approximately 1 percent of total FDI (and lowest level since 2009). Reinvestment of retained earnings has also increased significantly in 2013 and this suggests potential growth in business volume of existing companies in the future.

Sri Lanka’s financial account (as presented in new BPM 6 format) provides a better insight into actual foreign funds invested in the country during 2013 (including private equity and investments in the stock market). Table F shows the summary of equity and debt investments as given in the financial account.

When we analyse financial account data, we can note that there has been a decline in foreign funds invested in the country during 2013. Direct equity investments were down by 79.5 percent US $ 23 million (foreign private equity investments, if any would have been included in this segment). US $ 263 has been invested in both primary and secondary equity investments (including rights issues by listed firms) which are 25.5 percent less than last year. Total new funds invested in the form of equity and loans have declined by 14.2 percent to US $ 828 million in 2013. It is also interesting to note that 1/3 of total FDIs recorded in 2012 and 2013 appears to be local borrowings (difference between total foreign inflows to debt invest- ments and total loans included in FDI). This also implies that 23 percent of increase in private sector credit expansion is also included in FDI.

Increase in domestic savings

Domestic savings reached 20 percent of GDP in 2013, which is a marked improvement from last year. Increase in savings is mainly due to 32.6 percent increase in private savings (compared to 28 percent last year). As domestic savings increased, interest rates declined with monetary policy measures targeted at fuelling more economic activity. The government said that interest rates will not be reduced further despite declining inflation – a measure aimed to support retired people depending on interest income. In addition, the Central Bank imposed some interest rate ceilings for finance companies (in April 2014).

The country’s capital market is likely to see some changes arising out of increase in savings amid low inflation. In a low interest rate environment with slow credit growth, investor appetite for risky assets such as private equity is likely to increase.

Policy focus to promoted private equity and Jupiter’s strategy

For the first time in history, the Central Bank Annual Report has highlighted the importance in developing private equity indicating policy focus to develop PE in Sri Lanka. Whilst echoing many points highlighted by Jupiter through research articles last year, the CBSL Annual Report states, “As Sri Lanka moves to higher growth trajectory, it is imperative to strengthen the role of private equity as a major source of financing for Sri Lankan enterprises.”

Jupiter believes that PE could be developed as a main source of f unding to bridge the country’s savings – investment gap. Slow growth of FDI and low level of actual foreign inflows make a strong case to promote PE to attract foreign capital. Slow growth of private sector credit despite low interest rates also suggest of an over-leverage situation among businesses, which could be helped by boosting equity capital.

Developing PE is also essential to broaden and deepen the country’s capital market. Establishment of multiple PE managers/firms is important in this regard as it can help create PE benchmarks/track-record for the country as well as enabling PE industry to evolve into a professional, productive and sustainable service industry.

Jupiter will continue to seek exceptionally attractive opportunities in small and medium size businesses. Although Jupiter is a generalist investor, we continuously identify attractive sectors/ industries by analysing socio-economic trends, which are likely to deliver superior growth prospects. Jupiter believes that many trends seen in socio-economic data during 2013 signals the overall attractive investment environment and many niche opportunities for PE investors.

Note: All data used in compiling this report were obtained from Central Bank Annual Reports. Hence, the source is not mentioned for each data/info table.

(Indika Hettiarachchi, Jupiter Capital Partners Managing Director, is an experienced professional in private equity (PE)/venture

capital and is the founding Managing Director of Jupiter Capital Partners – a PE investment and advisory firm. He is a graduate (BS) of University of Wisconsin, USA, completed

a Master’s degree (MA) at University of Colombo and is also qualified as a Chartered Financial Analyst (CFA). Email: indika.h@jupitercapitalpart

ners.com)