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Tuesday March 28th, 2023

Sri Lanka import substitution should be temporary: economist

ECONOMYNEXT – Sri Lanka should not extend an import substitution strategy beyond the short term as changes are taking place in world which the island should not miss out on an economist said, as the island is battling a new cluster of Coronavirus.

Sri Lanka has placed the worst import controls since the collapse of the Bretton Woods system of soft-pegs in 1971, after the country’s currency plunged in March and April amid liquidity injections.

Private credit has since weakened but the import controls are in place amid excess liquidity in money markets.

Sri Lanka has placed the controls despite battling Coronavirus better that most countries.

“Sri Lanka is not the only country that is re-thinking its trade policy,” Dushni Weerakoon, the head of Institute of Policy Studies, a Colombo base think tank said responding questions at a webinar during the release of its annual State of the Economy report.

“It has been in the cards since the global financial crisis, we have seen a push-back against globalization and Covid 19 I think is accelerating that process.”

“The priority for the countries is to provide employment; there is a sense that if we protect our industry, give and them a relief period in which to recover.

“This is an unprecedented economic shock. We have no idea as yet what is the scale of the crisis is on the Sri Lanka economy.

“We have not yet seen the second quarter GDP growth rates that would capture in absolute terms what has happened. So we are working in the dark.

“So to that extent is understandable that a certain degree certain degree temporary import protection is offered.

Anti-trade economist nationalists have raised their voices in the West as seen by Trumpism, after the Federal Reserve triggered a financial and asset bubble which collapse around 2008, leading to run on banks and job losses, triggering massive state interventions in its wake.

Similar trade controls were seen after the Federal Reserve fired the ‘roaring 20s’ bubble and triggered the Great Depression. In the US, 1930 the Smoot-Hawley Tariff Act came was passed.

In Latin America where commodity exports suffered, import substitution became popular.

State led industrialization in particular was popularized by Raul Prebisch, the creator of Argentina’s activist pegged central bank, which was expected to sterilize the balance of payments.

The central bank model which was adopted by the Fed’s Latin America department and replicated in many other Latin American nations and also in Sri Lanka, triggering repeated currency crises and leading to sovereign default in many cases, analysts have said.

As the non-credible pegs collapsed countries turned to import substitution to ‘save foreign exchange’ instead of fixing monetary policy.

Most East Asian nations (and Gulf nations) on the other had adopted an opposite strategy backed by monetary stability (currency boards or highly credible pegs), and grew economies with foreign investment and created global value chains as well as domestic consumption.

East Asian nations which actively wooed foreign firms also over turned a Prebisch linked ‘dependency theory‘.

Free trade allowed living standards to soar, most recently seen in Vietnam, which embraced free trade early and had no domestic business class to oppose it as large companies were all state owned. Japanese branded goods are cheaper in Ho Chi Minh City than in Tokyo.

Ironically the push back against free trade in the West by nationalists and mercantilists during the Great Recession had come against East Asian industrial goods, while Latin America which pushed for import substation is still having currency troubles and sovereign defaults.

Meanwhile Weerakoon said there were new global developments that were taking place which Sri Lanka should not ignore.

“The sensible option is to view these as emergency measures, that once the economy starts to recover we have to re-think, because there are other developments that are taking place in the global economy,” she explained.

“Value chains have been disrupted but they are re-structuring and re-organizing and coming back in more compact forms.

“China will be at the forefront of some of these value chain networks in the Asian region.

“And Sri Lanka cannot afford to miss-out by holding onto unwieldy tariff regimes and other protectionist measures in key sectors that we want to ensure that we break into international markets.

“If you want to join the global production structures you need a seamless tariff regime for raw materials and intermediate goods.”

Weerakoon said Sri Lanka should also be cautious about state spending for ‘stimulus’ as there was a ‘debt overhang’ and the country had to repay foreign debt. Therefore some kind of credible fiscal policy was needed.

Sri Lanka’s sovereign bonds are trading at steep discounts which is making it difficult to roll-over them at the moment and forcing the government to make bullet repayments.

Sri Lanka however has controlled the spread of Coronavirus allowing people to actually go out and work, which is a real not financial ‘stimulus’ analysts say. Colombo/Oct19/2020)

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Sri Lanka stocks weaken for the second session on profit taking

ECONOMYNEXT – Sri Lanka’s stocks closed weaker on Tuesday for the second consecutive session mainly driven by month-end profit-taking by investors, according to brokers.

The main All Share Price Index (ASPI) closed down 0.56 percent or 51.81 points to 9,233.40.

The market has been on a downward trend since last week as investors are adopting a wait-and-see approach until more clarity is given regarding local debt restructuring after the International Monetary Fund approved the extended loan facility.

“The market is down as the selling trend continues,” said Ranjan Ranatunga of First Capital Holdings, speaking to EconomyNext.

“As there is a price decline in all shares across the board, combined with the month ending followed by margin calls, the market continued on a downward trend.”

The market generated a slow and thin turnover of 860 million rupees.

The main contributor to the turnover is Lanka IOC, following news that the Sri Lanka cabinet has granted approval for three oil companies from China, the United States, and Australia in collaboration with Shell Pl to lease 150 fuel stations for each company to operate in the local market.

The fears of debt restructuring mainly affected the banking and financial sectors, which dragged the index down for the day.

The market saw a net foreign inflow of 30.9 million rupees, and the total offshore inflows recorded so far in 2023 are 1.01 billion rupees.

The most liquid index, S&P SL20, closed 0.81 percent or 21.68 points down at 2,656.30.

The market saw a turnover of 860 million on Tuesday, below this year’s daily average of 1.8 billion rupees.

Top losers were Vallibel One, John Keells Holdings, and Hatton National Bank.

Analysts said the downward trend is expected to continue for the rest of the week as profit-taking is expected to continue. (Colombo/March28/2023)

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Sri Lanka rupee closes weaker at 325/328 to dollar, bond yields up

ECONOMYNEXT – Sri Lanka’s treasury bond yields were up at close on Tuesday and the rupee closed weaker in the spot market, dealers said.

A 01.07.2025 bond was quoted at 31.20/60 percent on Tuesday, up from 30.75/31.00 percent on Monday.

A 15.09.2027 bond was quoted at 28.25/29.00 percent, up from 28.10/60 percent from Monday.

Sri Lanka rupee opened at 325/328 against the US dollar steady, from 322/325 from a day earlier. (Colombo/ March28/2023)

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Sri Lanka Telecom on track rating upgrade track on planned stake sale: Fitch

ECONOMYNEXT – Sri Lanka Telecom has been place on watch for a possible rating upgrade after the government, which has defaulted on its sovereign debt said it will sell down its majority stake.

“The rating reflects the potential rating upside due to weakening linkages with SLT’s parent, the government of Sri Lanka (Long-Term Local-Currency Issuer Default Rating: CC), due to the government’s plan to sell its 49.5 percent stake in the company,” the rating agency said.

“Fitch will resolve the RWP when the proposed disposal becomes practically unconditional, which
may take more than six months.”

The agency said it expect SLT’s revenue growth to slow to a low single-digit percentage in 2023 amid weakening consumer spending due to consumers increasingly prioritising essential needs, such as food and medicine, as real income has fallen significantly following the currency depreciation and unprecedently high inflation.

The full statement is reproduced below;

Fitch Places Sri Lanka Telecom’s ‘A(lka)’ Rating on Watch Positive

Fitch Ratings – Colombo – 27 Mar 2023: Fitch Ratings has placed Sri Lanka Telecom PLC’s (SLT) National Long-Term Rating of ‘A(lka)’ on Rating Watch Positive (RWP).

The RWP reflects the potential rating upside due to weakening linkages with SLT’s parent, the government of Sri Lanka (Long-Term Local-Currency Issuer Default Rating: CC), due to the government’s plan to sell its 49.5% stake in the company. Fitch will resolve the RWP when the proposed disposal becomes practically unconditional, which may take more than six months.

SLT’s ratings are currently constrained by its parent’s weak credit profile under Fitch’s Parent and Subsidiary Linkage (PSL) Rating Criteria. SLT’s Standalone Credit Profile (SCP) is stronger than that of the state, reflecting the company’s market leadership in fixed-line services, second-largest share in mobile, ownership of an extensive optical fibre network and a strong financial profile. The extent of SLT’s rating upside, following the proposed disposal, will depend on the credit profile of its new parent, the linkage strength with SLT according to our PSL criteria, and the proposed funding structure.

KEY RATING DRIVERS

Disposal Plan: SLT announced on 20 March 2023 that the Sri Lankan cabinet has granted in-principle approval to sell the 49.5% stake in SLT held by the state. The disposal is part of a plan to restructure state-owned entities (SOEs) to improve the state’s financial position. SLT said steps have yet to be taken to identify potential buyers and it will take at least eight to 12 months to finalise the transaction. We believe the government will push through the disposal as SOE restructuring is an integral part of the IMF’s financial support to Sri Lanka.

Sovereign Ownership Pressures Rating: We assess the legal ring-fencing and access and control between SLT and the state as ‘Open’ under the PSL criteria, given the absence of regulatory or self-imposed ring-fencing of SLT’s cash flow and the government’s significant influence over the subsidiary’s operating and financial profile. SLT’s second- biggest shareholder, Malaysia-based Usaha Tegas Sdn Bhd with a 44.9% stake, has no special provisions in its shareholder agreement to dilute the government’s influence over SLT.

Higher Rating: However, the PSL criteria allows for a stronger subsidiary to be notched above the weaker parent’s consolidated profile in extreme situations, such as when a parent is in financial distress but the subsidiary continues to operate independently and its banking access appears unaffected. We do not believe SLT is at risk of default in the next 12 months, as it has sufficient liquidity and its debt does not carry cross-default clauses that can be triggered by the parent’s distress.

SLT’s ‘A(lka)’ rating therefore reflects its relativities with national peers, but is still below its SCP due to the drag from state ownership. We apply our PSL criteria because our Government-Related Entities (GRE) Rating Criteria states that in cases where the SCP of the GRE is higher than the government’s IDR, the relevant considerations of the PSL criteria will be applied to determine whether the IDR of the GRE is constrained or capped at the government’s rating level.

Weak Demand in 2023: We expect SLT’s revenue growth to slow to a low single-digit percentage in 2023 amid weakening consumer spending. Consumers are increasingly prioritising essential needs, such as food and medicine, as real income has fallen significantly following the currency depreciation and unprecedently high inflation. SLT’s subscriber numbers and minutes of usage have already fallen in 2022. Competition has also intensified, especially in the mobile segment, leading to lower realisation of recently introduced tariff hikes.

Weak demand should be offset to an extent by increased migration to SLT’s fibre-to-the- home (FTTH) network, from its own copper network, and subscriber additions. FTTH carries higher revenue per user than the copper network. SLT had 475,000 FTTH connections, a 35% increase yoy, by end-2022.

Weakening Profitability: We expect SLT’s EBITDA margin to narrow to around 34% in 2023 (2022: 35.6%) amid lower demand and ongoing cost escalations. All telecom operators increased tariffs by 20%-25% in late 2022 to tackle falling margins. However, the realisation into revenue remains weak, especially in the mobile segment, due to deep price cuts by one of the smaller operators and falling demand. SLT’s fixed-line business is able to maintain stable EBITDA margins due to the recent tariff hike and the FTTH segment’s higher revenue per user.

Leverage to Stabilise: We expect SLT’s EBITDA net leverage to remain around 1.3x in 2023 (2021: 0.9x, 2022: 1.3x) amid falling profitability. However, its leverage is strong for the rating. We expect capex of around LKR25.0 billion annually over 2023-2024 on network upgrades and expanding its fibre infrastructure.

Interest-Rate Hikes, Currency Depreciation Manageable: We expect SLT to maintain its EBITDA interest coverage closer to 4.0x over 2023-2024 (2022: 4.4x) despite interest rates rising almost threefold. Most of SLT’s debt is on variable interest rates, which will raise costs. SLT’s foreign-currency revenue, which accounts for 10%-12% of group revenue, is more than sufficient to meet the group’s foreign-currency operating expenses and interest costs. SLT had around USD10 million in foreign-currency debt at end-
December 2022, compared with USD40 million in foreign-currency cash deposits.

Sector Outlook Deteriorating: Fitch expects the average 2023 net debt/EBITDA ratio for SLT and mobile leader Dialog Axiata PLC (AAA(lka)/Stable) to remain around 1.3x (2022: 1.3x) amid weak margins and high capex. We expect sector revenue growth to slow to 8% in 2023 (2022: 15%), while the average 2023 EBITDA margin for SLT and Dialog should narrow to 31% (2022: 32%) amid low usage and high costs.

DERIVATION SUMMARY
SLT’s SCP benefits from market leadership in fixed-line services and the second-largest position in mobile, along with ownership of an extensive optical fibre network. SLT has lower exposure to the crowded mobile market and has more diverse service platforms than Dialog. However, Dialog has a larger revenue base, lower forecast EBITDA net leverage and a better free cash flow (FCF) profile than SLT. Dialog is rated at ‘AAA(lka)’, while SLT’s rating is under pressure because of the state’s weak credit profile.

SLT has a larger operating scale than leading alcoholic-beverage manufacturer Melstacorp PLC (AAA(lka)/Stable), which distributes spirits in Sri Lanka through its subsidiary, Distilleries Company of Sri Lanka PLC (AAA(lka)/Stable). Melstacorp is exposed to more regulatory risk in its spirits business because of increases in the excise tax, but this is counterbalanced by its entrenched market position and high entry barriers.

Consequently, the company can pass on cost inflation and maintain its operating EBITDA margin, supporting substantially stronger FCF generation than SLT.

KEY ASSUMPTIONS

Fitch’s Key Assumptions within Our Rating Case for the Issuer:

– Revenue growth to slow to 4% in 2023 amid falling subscriber numbers and lower usage due to weakening consumer spending;

– Operating EBITDA margin to narrow by 150bp to 34% in 2023 due to higher costs and lower volume;

– SLT to continue capex on expanding its fibre and 4G network with LKR25 billion spent annually in 2023 and 2024;

– Effective tax rate of 28% from 2023;

– Dividend payout of 33% of net income over 2024-2025

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

– Fitch will resolve the RWP when the proposed disposal becomes practically unconditional, which may take more than six months, and once Fitch has sufficient information on the new majority shareholder’s credit profile and linkages with SLT and the proposed funding structure.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

– Fitch would remove the RWP and affirm the National Long-Term Rating at ‘A(lka)’ with a Stable Outlook if the proposed disposal does not proceed and the linkages with the state remain intact.

LIQUIDITY AND DEBT STRUCTURE

Manageable Liquidity: SLT’s unrestricted cash balance of LKR14 billion at end- December 2022 was sufficient to redeem its contractual maturities of around LKR11 billion. SLT’s short-term working-capital debt amounted to another LKR10.0 billion and we expect the company to roll over the facilities given its solid access to local banks.

Liquidity is further enhanced by about LKR15 billion in undrawn bank credit facilities, although these are uncommitted. SLT typically does not pay commitment fees on its undrawn lines, although we believe most banks will allow the company to draw down the funds because of its healthy credit profile.

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