Shiran Fernando discerns a mismatch between prevailing sentiment and economic fundamentals

Weak sentiment locally is a worrying sign for the future trajectory of the national economy. The LMD-Nielsen Business Confidence Index (BCI) survey for April fell to a near six year low. While this offers proof of a slump in economic sentiment, the same is validated by the sense you get when you speak to most businesspeople, entrepreneurs or members of the public.

On the other hand, state institutions such as the Central Bank of Sri Lanka (CBSL) and key policy makers paint a far less pessimistic picture. They back their take on the economy with hard evidence of the improvement in economic fundamentals compared to a few years ago.

LOW SENTIMENT In financial markets such as equities, the direction of stock indices can be driven by sentiment, which in turn is influenced by emotional factors. In certain cases, it can override the fundamentals that are driven by facts or performance and point to a different direction to that of sentiment.

A similar comparison can be made with respect to the Sri Lankan economy. A slew of events over the last few years have led to this decline in sentiment.

The uncertainty surrounding the operating environment (e.g. changes in the tax structure), lack of policy consistency and clarity, failure to implement key policy initiatives, unstable political climate, adverse impacts of weather and sharp decline in economic growth are only a few factors to consider. However, some of these factors require more rational and contextual thought.

CASE IN POINT The Sri Lankan Rupee has not witnessed its greatest performance to date in the first five months of this year – the rupee depreciated by about 3.4 percent against the dollar during this time. This has amounted to more than two percent of the depreciation witnessed in 2017.

On the face of it, the currency weakness observed this year may seem worrying. However, when viewed from a more global context, it is easier to understand why the rupee has depreciated as much as it has so far this year.

In 2017, the US Dollar weakened by close to 10 percent against a basket of currencies. This year and since February, the dollar has strengthened on the back of positive data vis-à-vis an improving outlook for the US economy. As a result, money has flowed out of emerging markets such as Sri Lanka and back into safe havens such as the US Treasury bond market.

A combination of these two factors and rising oil prices has led to the currencies of countries such as Indonesia, the Philippines and India depreciating by more than 3.4 percent compared to the Sri Lankan Rupee. This context is not clearly understood by most with the rupee weakness being linked to domestic reasons more than global ones.

THE FUNDAMENTALS Despite low growth in 2017, exports and inward foreign direct investment (FDI) reached an all-time high. The Central Bank has been able to increase foreign reserves to reach such all-time highs. This has been achieved through carefully purchasing dollars in foreign exchange management and prudent debt refinancing strategies (such as borrowing by raising debt through international capital markets).

The debt management strategy reflects a more proactive approach that will assist in creating a buffer in the period from 2019 to 2022 where Sri Lanka is expected to refinance about US$ 3.9 billion in external debt annually.

Other indicators point to more favourable conditions as well.

Headline inflation as measured by the Colombo Consumers Price Index (CCPI) declined to 3.8 percent by the end of April from 7.3 percent in March. This drop was largely driven by improved food supply.

In the near term – with the fuel price revision, bus fare increases and other similar non-food item price hikes – we could witness inflation edging back to mid-single digit levels but not rising beyond a level to cause concern.

On the fiscal front, we continue to observe positive developments.

After recording a primary surplus – i.e. the difference between revenue including taxes collected by the government minus non-interest expenditure – for the first time since 1992, the improvement in revenue collection continued in the first quarter of 2018. Total revenue was up by 7.6 percent from January to March compared to the corresponding period in 2017.

FEEL-GOOD FACTOR The mismatch between present economic fundamentals and prevailing sentiment is evident. Now the relative macroeconomic stability achieved by policy makers needs to be translated into tangible benefits for consumers and businesses alike. This will make for a feel-good factor that will arrest the decline in sentiment.

This may prove to be a challenge as populist measures that would create such an improvement in sentiment could derail hard-earned stability.

A greater focus on growth, implementation of vital policy initiatives and political stability would be key ingredients in improving sentiment regarding the economy.