STOCK MARKET, ECONOMY AND BUDGET PROPOSALS
The two weeks of trading at the Colombo Stock Exchange (CSE) leading towards the budget speech revealed mixed sentiment while the All Share Price Index (ASPI) lost 2.3 percent or 172 index points.
The reasons could be that the local sentiment was dented with majority expecting 2015 budget to be a giveaway with many election goodies at the expense of fiscal discipline and growth orientation.
Nevertheless the foreign investors seemed undeterred with global portfolio managers accumulating Sri Lankan stocks which braked the otherwise downward movement of the ASPI. Also we did witness shifts in portfolio positions amongst the global players active in the Colombo bourse. With foreign buying strong, local HNWI’s and institutions too participated in shifting their positions enabling the average daily turnover during the two week period to be at Rs. 1.7 billion which is around 50 percent more than the year-to-date 2014, average daily turnover level. Net foreign buying was at Rs. 1.1 billion with total overseas buying recorded at Rs. 4.1 billion.
NO DIRECT IMPETUS
Then on Monday 27th October, the first day of trading after the 2015 fiscal budget was presented in parliament, ASPI edged higher by 48 points and foreign buying continued reflecting optimism over the medium term economic trajectory of Sri Lanka and the next year’s budget proposals. However this time around the budget did not provide direct impetus to the capital markets but merely mentioned the importance of the same for making Sri Lanka’s economy more vibrant. Albeit indirect impact either favorable or negative from a country’s fiscal budget proposals are many for the stock market and therefore it is important to understand how these elements would influence investor and trader sentiment.
With lower tax rates, probability for self-assessed income tax payment would increase and could lead to higher revenue collection by the tax authorities
With the government budget having to manage its fiscal consolidation process as well as abide by the government’s needs and wants specially when national elections are around the corner requires a fine balance and the task of preparing such a fiscal plan is not easy, therefore the professionals and bureaucrats involved in the exercise deserves much praise. Having said that 2015 fiscal budget has both pros and cons when viewed from an independent and liberal viewpoint.
With the end of war, while consolidating the new found peace, the government was able to focus attention in improving the national economy. And with the new found sense of security, upbeat sentiment jump started the economy which was anyway enjoying healthy growth rates despite the war. (During the two decades leading towards 2009, Sri Lankan economy had grown by an average 5.7 percent per annum in real terms) Thereby real GDP growth surpassed 7 percent and is now expected to edge further higher to 8 percent levels and be sustainable in the medium term.
ADRENALINE RUSH
This economic growth trajectory taken as it is would be sufficient to create an adrenaline rush amongst the equity market investors.
While free market economists would agree that by making the fiscal plans more liberal and equitable, Sri Lanka could easily achieve a sustainable real GDP growth rate of over 10 percent during the medium term, albeit 8 percent which the current target is without doubt relatively better than any other frontier or emerging economies.
Also the commitment to fiscal deficit targets should be praised, despite ballooning of recurrent state expenditure, fiscal deficit has been on the downward trend since 2009, from 9.9 percent of GDP to 5 percent of GDP in 2014 and targeted at 4.6 percent of GDP for 2015 as reported in the budget speech last week. Therefore these twin indicators, the rise in real GDP growth rate and the narrowing of fiscal deficit bodes well with investors. Specially the global fund managers eyeing both listed equity and debt would be encouraged with the current track record of fiscal management.
LOWERING TAX
The highest tax rate for personal income has been reduced from 24 percent to 16 percent, which is a 33 percent reduction in the tax rate. This lower tax rate was earlier granted only to qualified professionals in last year’s budget while this year around it has been made the norm.
This is a prudent move in widening the tax base and increasing government tax revenue. Personal incomes which are tax-free for the first Rs. 600,000 are then taxed in brackets of incremental basis using rates of 4 percent, 8 percent, 12 percent and the maximum now at 16 percent. Also lowering the tax rate amongst high income earners would propel more economic activity with the availability of an increased disposable income. This spending would drive economic growth while also allowing the government to collect more indirect tax revenue in the form of VAT.
Further, lower tax rates would become an automatic stimulant against tax evasion. It is common knowledge in Sri Lanka that higher income earners (other than from employment who will be taxed at source) tries to reduce their tax burden by obtaining the services of uncanny consultants and officials again pocketing out a hefty cash pile. With lower tax rates, probability for self-assessed income tax payment would increase and could lead to higher revenue collection by the tax authorities. While computerization of the tax departments would assist in this endeavor, soft service improvements such as online tax filling, more friendly service identifying the tax payer as a customer of the Government etc. would have a significantly higher positive impact in collecting more tax revenue. Also the proposal of netting tax evaders and collecting back taxes from this group is a most welcome proposition though impartiality should be practiced in collecting these dues if the nation is actually to achieve its objectives rather than allowing a selected group to be immune to the newly brought proposals.
Advocates of pro-capitalist and liberal policies would be in favor of reduction in taxes in whatever form. Therefore the same would apply to capital market investors. The reduction of VAT rate from 12 percent to 11 percent therefore would be viewed positively.
Cynics may argue that this is a move to maintain or reduce retail prices of goods ahead of elections next year, but on the contrary irrespective of whether the earlier argument is correct or wrong lower taxes would encourage more transactional volume which could more than compensate for the lost revenue from the 1 percentage point reduction in VAT. Another welcome move has been without creating complexities like in the past there are only two categories of products and services which are liable for VAT; one been totally exempt from VAT and the other been taxed at a flat rate of 11 percent. Then the multiple taxes which were earlier payable when importing vehicles has been negated and instead a fresh excise duty has been imposed, while ensuring the effective tax cost is lower. While this is an welcome move for the motor sector, the policy is also moving in the correct direction in simplifying tax policy in the country. Further increased importation of vehicles would also be a positive for the banking and finance sectors in expanding their loan books.
SLIDING GOVERNMENT DEBT
The state-driven investment of essential infrastructure necessitated overseas debt funding with many preferential credit lines been already exhausted. Hence the current government faced strong criticism on the quantum of overseas debt and the resultant interest payments. However the facts which were disclosed during the budget speech addressed these issues clearly since overall government debt has once again been in the downward trend currently at around 75 percent of GDP.
However what is encouraging is that the resultant interest cost from these government borrowings has once again been in the decline and down from 5.1 percent of GDP in 2013 to 4.5 percent in 2014 and targeted at 3.8 percent in 2015, clearly depicting that given the expansion in GDP the serviceability of these government debt is on the rise. However the caveat for overseas debt and interest payment would be the exchange rate balance. And unless otherwise a windfall of FDI’s appear, SL Rupee would weaken against other hard currencies with the normal depreciation been around 3-5 percent p.a.
Another attraction for number crunchers in the budget proposals were the percentage reduction in Defense expenditure from 5.5 percent of GDP to 3 percent of GDP. Though defense is an important aspect of any nation and safeguarding the territorial integrity of a country which came out of a 3 decade old conflict should be beyond compromise and justifies higher defense expenditure. However the general thinking is that when defense cost reduces the savings of which would be transferred to capital investments or directly assist in the narrowing of the fiscal deficit. Nevertheless if this is the case it is economically sound while if savings from defense expenditure is channeled to assist other recurrent cost categories such as increasing state sector employment etc. would not be wise from the viewpoint of bettering Sri Lanka’s economy.
STATE SECTOR EXPANSION
Moving on what the investors, businessmen, corporates and entrepreneurs would be most displeased with regard to the budget proposals would be the expansion in the state sector. The recurrent government expenditure is planned to increase by 10 percent year-over-year in 2015 with a further impetus to creating new state sector jobs. The canny political thinking is to create jobs for the electorates at the expense of the public coffers and safeguard the voter base. Also this move creates a vicious cycle which would be politically suicidal if changed. However enlarging the state sector on its own is resulting with a budgeted recurrent expenditure of 13.5 percent of GDP in 2015, would be sufficient to negate all the economic positives for the economy in the medium to long term. The critical risk been that Sri Lanka’s population is no longer young, it is aging and the state sector employment is growing year-over-year and now is around 1.5 million strong, which is approximately 13 percent of the workforce within Sri Lanka. Overall population aging and the state sector employment rising equates to a shrinking of the private sector employment in percentage terms. The private sector which should be the engine of growth in any vibrant economy is been crowded out with the current move towards expanding the state sector and will be burdened to pay the salaries and pensions of the state sector!
EPF CONTRIBUTION AND PVT SECTOR
The increase in EPF contribution due from the employers would discourage private sector job creation and also increase the personnel cost of corporates. Therefore most companies would witness whatever the volume driven revenue benefits generated in terms of lower VAT been eroded by way of increase in EPF costs. Also given the outlook, salary increases in the private sector would become sticky and the employers could not be blamed.
This affects the disposable income which would in return hold back overall economic transactions. While instead of increases in EPF contributions, if the employees were given the freedom to contribute their pension contributions to a pension/mutual fund of their choice the medium to long term impact would have been much more positive.
The contributors having the choice of selecting professionally managed funds with the highest track record of returns, employers would have been more liberal with pay rises, the fund management industry would grow and competition would ensure better prospects for all stakeholders.
CONTROVERSIAL PREFERENTIAL DEPOSIT RATE
Then the final point in the 2015 budget proposals which attracted significant attention was the preferential deposit rate of 12 percent been offered to senior citizens through the state banks.
Advocates of pro-capitalist and liberal policies would be in favor of reduction in taxes in whatever form. Therefore the same would apply to capital market investors
This can be viewed in two angles. In a pure economic point of view, this policy creates a distortion to the market based identification of interest rates.
When the market deposit rates are around 6 percent, a preferential rate of twice that and which is higher than the market lending rates is offered to the senior citizens! But on the flip side it could be argued that it is a social requirement, given the senior citizens who were used to living on interest income can no longer be comfortable with the low interest rates. Specially with nearing elections this societal need has to be addressed. However the question remains as to why such a high real interest rate was decided, since in the past when inflation was at low teens, the deposit rate offered may have been few percentage points higher resulting with a real interest rate of around 3 percent. But now when inflation is running at 6 percent, why provide a preferential real interest rate of 6 percent over and above inflation? Also this move would create a shift in funds from the private sector banks and finance companies to the state sector banks and though this would not make a dent in balance sheets of the private banks the possibility of a deposit squeeze amongst smaller finance companies cannot be written off.
Therefore this move would further propel the small scale finance companies to pursue mergers or allow themselves to be acquired. However the consolidation of the financial sector is a clear positive and though the entire process would take time to complete sooner it is done more strong the financial sector of the country would be.
With the market now absorbing the contents of the fiscal budget proposals, would identify that there is no significant change in the proposals compared to the past few years. And the strengthening of the fiscal position would encourage further capital market investments. With the earnings season also having started, investor attention would gradually shift to the corporate profit releases with all indications suggesting stronger corporate earnings when compared to the previous year. Therefore some results-driven price surges in certain stocks could be visible during the coming weeks while the market trend could remain upward though pace is expected to slow.