Sri Lanka

March 22, 2011

Executive Summary
We Are Sri Lanka Rupee Bulls
Within a year, the LKR will be closer to Rs 125 than Rs. 131 against the USD
Drops in consumer durable imports and investment goods imports, coupled with reasonable export growth should lead to some moderation in the trade deficit and a more significant From current levels, on a one year horizon we expect to see appreciation in the Rupee because we see falls in some key import categories due to a sharp fall in growth.

This is not a Short Term View

We remain uncertain on the outlook for rates, and unlike the LKR we are not YET making a Strong Bullish call on L-T LKR Bonds
Please See Appendix for Further Data and Analysis

improvement in the current account deficit. With Capital Flows picking up a little, we project a slight BoP surplus in 2012. This is not a near term view on the Rupee, which will continue to be volatile depending on the impacts of varied financial and trade flows. A collapse in Credit Growth would hasten the drop in imports that we expect. This may occur naturally, but most likely a further sharp tightening of Monetary Policy may be needed.

Makig a Strong Call

In a moment like this, it is easiest for an Analyst to run away and not make a call, just when everyone seems to need one. We have always maintained that: When we do not have a view we will say so. But when we do have a view, we will express it strongly As such when we do not have a strong view, we make no apologies for not making a strong call, or to signal our uncertainty as to future direction. As such in our most recent Monthly Economic Advantage Reports, we have often indicated a high level of uncertainty in terms of having a view:
We believe there is a near equal probability that the Rupee could appreciate or depreciate from current levels Economic Advantage Report, March 2012

In summary, there is a reasonable likelihood that most financial variables can move in both directions or stay near current levels. Unfortunately we cannot give a clear sense of direction. As such we maintain our view that the level of uncertainty is exceptionally high. Taking positions to maximize returns based on directional views on movement on rates/FX should be avoided and the focus should be to risk mitigate by hedging positions as most suited to asset liability structures.- Economic Advantage Report, December 2011

We were unfortunately not as bearish on the Rupee as we should have been. Hedged views such as the above were the best we could do given our uncertainty. These views were probably not very useful to most clients. But now, we do have a strong view on the direction of the LKR from current levels on a one year horizon. Our view is that Within a one year horizon from todays LKR level, we believe we will see the currency appreciating and the LKR will be closer to Rs. 125 than the current levels of around Rs 131 against the USD.

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Why do we see LKR appreciatory pressure ?

Please refer the appendix for charts on this. To put it simply the reason we expect to see appreciating pressure is because we see a collapse in many import categories together with a sharp collapse in GDP growth. We were earlier indicating growth numbers for 2012 could be marked down to the 6% level. We are now even more pessimistic on growth and think we should not rule out growth levels significantly below the 6% mark in the second half of 2012. Key assumptions in our forecast for 2012 are a 15% drop in Consumer Durable imports (after a 67% rise in 2011) and only a 5% growth in Investment Goods Imports (after a 60% rise in 2011). These imports could actually come in much lower than this. As such we could prove to have taken conservative assumptions on these import drops. The price of Oil prices is assumed to rise 13%, but we have assumed a 5% drop in volumes due to better rainfall reducing the need for Thermal generation (opposite effect of last year). This is expected to result in total import spending on Petroleum rising by 7%. These numbers and assumptions are of course highly dependent on rainfall expectations and global oil prices. An Iran crisis could lead to these numbers been proved optimistic. However if the Government passes on further pressure on the imported Oil to the Consumer/Business as they did in Feb, due to reduced spending power we could see greater drops in the other import categories than what we have assumed. This we feel could compensate for the higher oil bill. Export growth is conservatively projected to be only 12%, significantly below the 22.4% of last year. As it is higher than the overall import growth forecast of 6% projected, the Trade Deficit is projected to fall from USD 9.74billion to 9.64billion We expect to see Net Remittances growing by 10% in 2012 which would appear a conservative assumption relative to last years growth of 25%. Services income (powered by Tourism) is projected to grow 30% in 2012 ( as against an estimated growth of 45% in 2011) . Due to these factors the Current Account deficit is expected to fall USD4.1bllion from an estimated USD4.9billion last year. The key of course is the Capital Account. We expect Capital inflows to rise a little from US3.87billion in 2011to USD4.186billion in 2012. The numbers on the Capital Account are clearly

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hard to project with any reasonable degree of accuracy, but the recent flows in into Equity and Bond markets are above the projections we have taken. With the current account being better, and this slight improvement in the Capital Account, we should lead to the BoP at a marginal Surplus this year.

So Why Are We Not Seeing This Already?

Though credit growth has slowed from the torrid pace of the second half of last year, talking to some key financial institutions it is clear that until Feb 2012, all we have seen in slowdown of sorts not the collapse thats needed. We believe will need a real collapse in Credit Growth to see the rupee appreciate again on a sustained basis. The CBSL continued to sterilize its limited intervention in the Fx market. (In non economist language, they are continuing to pump money into the system replacing reductions in liquidity on account of pressure on the balance of payments. This was done in order to avoid rates surging due to an even greater liquidity shortfall than what we see today). But if the CBSL had not sterilized (not intervened in terms of supplying liquidity), allowed for a further liquidity shortfall, the resultant rates surge( far worse than seen in the last few months) would have caused Credit and imports to collapse much sooner. Furthermore given the concern on the Rupee, and the Economic uncertainties seen, in the near term there may have been accelerated purchases of imports to attempt to avoid losses due to expectations of further depreciation. This is supported by the liquidity pumped in due to sterilization. But accelerating imports by Importers cannot go on forever. Given the weakness in the rupee, Credit Growth may have to be almost halted for the Rupee to become stable and appreciate. This can happen by allowing liquidity to naturally tighten, or through quantity measures (Thus credit restriction of an 18% growth was far too high if quantity measures are what is being used). Irrespective of CBSL action, going forward it is clear that economic uncertainty and hit to confidence itself will cause many imports to be cut back this year. Our import drops are based on this uncertainty impact itself reducing imports rather than the impact of significant CBSL actions to tighten/non sterilize. Action by the CBSL could cause imports to fall further and the BOP surplus to be greater than what we have now projected.

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When Do We See the Appreciation Happening?

Timing this is the hardest part. In the past when we have become strongly bullish or bearish on asset classes we have often been proved to be too early with our contrarian call. However, while we have often later been vindicated, the exact timing of our calls could have been better. Thus it could very well be that the Rupee will fall sharply from here before starting on the appreciating path. That this is an absolute top or even close to it is not the call we make.

What Could Make Us Wrong?

There are of course a number of risks to our forecast. 1. The situation with Iran, the risk of this on oil prices, the specific impact of this and how it is passed on to Sri Lanka, can overturn our view. 2. The CBSL may not tighten monetary policy, and credit growth will continue unchecked as the confidence impact on imports is not what we anticipate 3. Capital inflows disappoint/or Investors sell out of Sri Lankan Financial Assets. Recently the trend has turned quite positive but any major sales particularly by Bond holders would be a significant move against our assumptions. We have assumed Net Capital Inflows for 2012 at slightly more than what was seen in 2011.

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Appendix
Figure 1: Sri Lankan Balance of Trade with Frontier Trade Forecasts
Source: Sri Lanka Census and Statistics Department,CBSL, Frontier Research.
25,000
50% 6%

% Figures are YoY growth

8%

20,000

15,000
-28%

32%
9%

US$ M illions

10,000 5,000 0
(5,000)
-13% 21%

22%

12%

(10,000) (15,000) 2008 2009 Total Exports 2010 Total Imports 2011P 2012E 2013E

Balance of Trade

Our base case projection is that the Balance of Trade Deficit will fall this year despite the rise in oil prices due to the slowdown in import growth, in the face of continuing export growth.

Figure 2: Sri Lankan Consumer Durables and Frontier Forecasts

Source: Sri Lanka Census and Statistics Department,CBSL, Frontier Research.
2,500

% Figures are YoY growth

67.1%

2,000 -15%

6.1%

US$ M illions

1,500 69.2% 1,000 -30.70% 500

0 2008 2009 2010 2011 2012 Exp 2013 Exp

The Increase in Durable Imports in 2011 from 2010 was 79% of the estimated BOP deficit of 2011. Imports of Consumer Durables are assumed to fall by 15% in 2012.

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Figure 3: Sri Lankan Petroleum Imports and Frontier Forecasts (together with assumed Oil Price)
Source: Sri Lanka Census and Statistics Department, CBSL, Frontier Research
6000

YoY growth
5000

5% 7% 53.4%

US$ M illions

4000

Annual Avg Brent Prices

39.3%

3000 -35.7%
2000
96.94 $/bl 61.74 $/bl 110.95 $/bl
79.61 $/bl

125 $/bl

125 $/bl

1000

0 2008

2009

2010

2011

2012 Exp

2013 Exp

Figure 4: Sri Lankan Petroleum Imports and Frontier Forecasts (together with assumed Oil Price)
Source: Sri Lanka Census and Statistics Department, CBSL, Frontier Research
6,000

5,000

YoY growth

4,000

3,000
76% 0%

10%

2,000
33%
-1% 5%

1,000

69% 19%

10%

-24%

0 2008 2009 Machinery 2010 2011 Other 2012 Exp 2013 Exp

Transport

The chart shows the total investment goods and the share of Machinery and Transport Equipment within it.

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Disclaimer: This information has been compiled from sources believed to be reliable but Frontier Research Private Limited does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment as of the date of the material and are subject to change without notice. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The recipient of this report must make their own independent decision regarding any securities or financial instruments mentioned herein. Securities or financial instruments mentioned herein may not be suitable to all investors. 8|P a g e