Overview

The financial year 2013/14 was a period of economic recovery, both in Sri Lanka and globally. The macroeconomic tightening measures taken in 2012 and the easing of conditions in 2013 saw a notable improvement in Sri Lanka’s macroeconomic fundamentals during the year under review. Inflation was under control, interest rates declined and the balance of payments improved. Sri Lanka’s economy, like many other emerging/frontier markets, also experienced volatility in the second quarter in the wake of tapering of quantitative easing in the US. However, stability was established promptly and the initial impacts of tapering were not substantial.

Nevertheless, domestic economic activity remained subdued through much of the financial year, though a mild improvement was seen in the second half. Consumption and investment trends remained modest during the period and this was also reflected in low demand for credit in the banking sector. Therefore, even though headline economic growth was robust, this has not yet fully been reflected in most corporate earnings.

The global economy saw important improvements in the key markets in which we operate. Despite market gyrations due to announcements relating to tapering, the US economy continued its positive growth momentum. The negative economic growth in Europe bottomed out and tail risks diminished significantly. Whilst many emerging economies faced volatility in the wake of tapering, the long term fundamentals for many of these economies remain bright. Global commodity prices also remained fairly moderate in the wake of subdued demand. This served to support margins in some of our manufacturing businesses.

The Sri Lankan Economy

Growth
Economic growth in Sri Lanka showed some signs of recovery in the latter part of 2013, following the tightening measures taken in 2012. Growth rates increased throughout the year and full year 2013 GDP growth was reported to be 7.25%. Growth was fairly broad based with improved performance in all three sectors of the economy.

The Agriculture sector grew at 4.7% as improved rainfall supported recovery in major domestic crops such as paddy. This proved supportive for the Hayleys Agriculture sector, which has presence across the entire value chain in Sri Lankan agriculture. However, other crops such as rubber and coconut were adversely affected by the weather, which created challenges for the Hayleys Plantation sector, while causing higher raw material costs for the Hayleys Purification and Fibre sectors.

The Industrial sector grew by 9.9% in 2013 with strong growth in construction, energy and apparel. Hayleys businesses within all of these sectors also performed well. The Construction Materials sector reaped the benefits from continued growth in infrastructure and buildings, also helped by low raw material prices in the global market, which supported margins. The Sri Lankan apparel sector recovered in 2013, with improved exports in the second half of the year, generating demand for Hayleys Textiles sector.

The Services sector of the economy recovered in 2013 with growth of 6.4% led by transportation and trading. The strong growth in the transportation sector was primarily in domestic transportation, whilst international transportation as reflected in the Ports and Aviation
sub-sector had more modest growth of 2.8%. With the recovery in exports and new policy measures to enhance Sri Lanka’s position as a hub for logistics and maritime transportation, the longer term prospects for international transportation are positive. The Hotels and Resorts sub-sector continued to grow in a robust manner (22.4%, albeit from a low base), reflecting the anticipated growth in the tourism sector, supporting demand for the Hayleys Leisure and Aviation sector.

Interest Rates
The growth momentum in the economy was supported by conducive interest rates. Whilst the Central Bank of Sri Lanka (CBSL) began to reduce policy interest rates in December 2012, followed by another 50 basis point rate cut in May 2013, market interest rates stayed elevated till mid-2013. Subsequently, market lending rates declined throughout the rest of the year as demand for credit in the economy was sluggish and gold backed lending declined, creating high liquidity in the banking sector. Furthermore, performance of key state owned enterprises also improved in 2013, resulting in less utilisation of bank credit that added to bank liquidity. By March 2014, the prime lending rate had declined to 8.6% from a peak of 14.4% and market excess liquidity amounted to Rs. 155 bn in term repo auctions. During this period CBSL reduced the statutory reserve requirement by 200 basis points in July and further reduced policy interest rates by 50 basis points in October 2013 and a further 50 basis points in January 2014.

Inflation
Despite interest rates declining substantially, inflation also moderated during the year. In the early months of 2013, point to point inflation was elevated due to base effects, but steadily declined thereafter. Several factors contributed to this decline, including limited demand driven pressures as reflected in core inflation levels falling to record low levels (2.1% in December 2013), moderate global commodity prices and favourable weather enabling sufficient agricultural supplies. Accordingly, a 4.2% inflation rate was recorded in March 2014.

Whilst headline inflation remained moderate throughout the year, there were diverse impacts on costs of production. Energy prices in terms of electricity and industrial and consumer fuels have increased in successive years 2012 and 2013 and their implications continued to be felt in all our manufacturing operations. We have taken several measures across the board to improve energy efficiency and also incorporated alternative energy solutions in our factories.

In terms of raw material costs, most global commodity prices had declined. However, in the coconut sector, prices had increased due to production declines affecting the cost of production for our Purification and Fibre sectors. Costs in the Fibre sector in Sri Lanka had also risen due to demand for raw fibre exports, particularly from China.

External Sector
The external sector had mixed results in 2013. In the first half of the year exports contracted by 4.5%, but recovered with strong growth in the second half of the year resulting in export earnings reaching US$ 10.4 bn, a growth of 6.3% for the full year. Agricultural exports saw a strong growth of 10.7% and while overall industrial exports grew by 5%, when apparel is excluded, other industrial exports contracted by 8% during the year. Apparel exports grew by 13% in the year 2013.

Export of services including BPO, earnings from tourism, international transportation and remittances also remained strong during the year. Hayleys has positions in most of these business sectors. Earnings from tourism increased by 35% during the year, whilst gross earnings from BPO and telecommunications reached US$ 719 mn. The BPO sector will benefit due to Sri Lanka being recognised as the outsourcing destination of the year 2013 by the National Outsourcing Association of the UK.

Imports declined in 2013 with a contraction in import expenditure by 6.2%. Imports of consumer goods remained moderate, growing at 6.3% in 2013.

Expenditure on investment goods and intermediate goods declined. Among intermediate goods imports, the import of textiles declined by a significant 10% despite an increase in apparel exports. This reflects a welcome increase in backward integration in the apparel/textiles industry, where Hayleys MGT has played an important role since 1993, manufacturing world class fabrics for Sri Lankan apparel exporters. Expenditure on fuel imports declined sharply by 14.6% due to lower requirements for heavy fuel for electricity generation while the share of hydropower remained strong.

The improvement in export earnings and moderate import expenditure resulted in the trade balance and current account deficit improving in 2013. The current account deficit in 2013 declined to US$ 2.61 bn from US$ 3.98 bn in 2012. The improvement in the current account deficit was an important contributor to the increased stability seen in the Sri Lanka rupee in 2013. At the same time there were capital account inflows through the issue of a US$ 750 mn international bond by the National Savings Bank, a US$ 100 mn bond by DFCC Bank in late 2013 and a US$ 500 mn sovereign bond in January, 2014. Foreign inflows to equity and debt markets also continued, despite some conversion of foreign-held investments from treasury bonds to bills in mid-2013.

Currency Markets
Following the depreciation of the Sri Lanka rupee in 2012, the rupee recovered and maintained stability in the first half of 2013. In mid-2013 however the rupee depreciated in line with global market movements as the US Federal Reserve announced the tapering of quantitative easing. Between June 2013 and August 2013 the rupee depreciated from Rs. 126 to Rs. 134 against the US dollar. However, with the delay of tapering in September, 2013, the rupee subsequently recovered to end the year at Rs. 131 to the US dollar. By March 2014 the rupee remained stable, appreciating slightly to Rs. 130.69 against the US dollar.

Whilst depreciating marginally by 3.4% against the US$ in between April 2013 and March, 2014, the Sri Lanka rupee appreciated against several major international currencies during this period and performed better than most emerging market currencies. For example, the Sri Lanka rupee appreciated against the Indian rupee by 6.4%, the Indonesian Rupiah by 10.6% and also the Japanese Yen by 6.6%. The appreciation of the Sri Lanka rupee against competing exporters such as India, Indonesia, Malaysia (by 2%) Vietnam (by 2.5%) is a negative for Sri Lankan exports, but is a positive for imports from these countries. These emerging economies are significant competitors for the Hand Protection, Purification and Fibre sectors of Hayleys. From an export perspective it is a positive that the Sri Lanka rupee depreciated against the Sterling Pound (by 13.2%) and the Euro (by 10.9%) during this period.

The Global Economy
The US economy recovered in 2013 and is expected to continue its growth momentum in 2014 as well. The recovery is underlined by a significant improvement in household and government finances as substantial deleveraging has taken place creating space for higher consumption. Manufacturing has also shown continued growth in the latter half of 2013. Medium term manufacturing prospects have also improved in the US driven by improved competitiveness in energy intensive industries due to the shale gas revolution. Whilst unemployment has declined indicating labour market improvement, there has also been a decline in labour force participation as baby boomers retire. The improvements in the US economy enabled the Federal Reserve to begin tapering its bond buying programme, known as quantitative easing. As a result, interest rates in the US began to edge up and the US dollar strengthened in global foreign exchange markets. The US is an important market for Hayleys exports, accounting for 8.6% of the Group’s turnover.

The improvements in this market, along with its positive knock-on effects in the rest of the global economy, are undoubtedly a positive for Hayleys exports.

Europe limped out of technical recession in 2013 and tail risks of breakup have reduced considerably. Nonetheless, Europe is yet to come close to robust economic growth. A number of structural issues remain in the economy, including high debt overhang, poor growth, structural unemployment, stagnant prices and a weak financial sector that lacks the muscle to finance growth. Accordingly, whilst Europe has stopped contracting, the economy appears to be stagnating unless there are substantive reforms to labour and financial markets, both of which require deeper political reform, which will not happen overnight. Europe is another major market for Hayleys exports, particularly for Hand Protection and Fibre. The fact that the negative EU growth rate has bottomed out is indeed a positive for Hayleys, but Europe’s economy is yet to provide the tangible growth that would create a meaningful impetus to demand.

The year 2013 was challenging for many emerging economies, particularly so for those which had high current account deficits and budget deficits. US Federal Reserve tapering resulted in outflows of foreign investments in debt and equity markets in many emerging economies, resulting in weakening currencies and rising interest rates. India and Indonesia were among the worst affected. Other economies including Russia and Brazil have experienced more structural weakness, as commodity prices remained moderate, thus showing up more fundamental economic weaknesses such as under-investment in infrastructure. Many emerging economies, particularly in the Middle East and the former Soviet region, are important and mature markets for Ceylon (Sri Lanka) tea. Hayleys Group has also made efforts in recent years to increase exports to emerging economies, taking advantage of the long term prospects in these markets. Emerging economies are also increasingly important sources of tourists for Sri Lanka.

Outlook

Moderate interest rates, subdued inflation and global economic recovery should enhance overall consumer and investor confidence in Sri Lanka in 2014. However, the economy is still recovering from significant fiscal and monetary contractions in 2012 and the resultant declines in lending and consumption. A number of large projects and new policies such as the Commercial Hub Act have enhanced investment potential in Sri Lanka and these could act as triggers for renewed confidence to spur economic activity in 2014 and beyond. One of the important risks in the coming financial year will be the weather. A significant drought will have a detrimental impact on Sri Lanka’s current account balance, fiscal position and inflation. It will also be a negative for agriculture and hydropower generation.

The outlook for the global economy is also positive, led by recovery in the United States. However, there remains a lot of uncertainty as the global economy eases out of unprecedented monetary expansion, making market reactions unpredictable. Volatility can be expected in emerging markets, particularly those with fiscal and external imbalances. Commodity prices are also expected to remain relatively moderate, which would be supportive of several Hayleys export manufacturing businesses.