global & local economic insights - nov 2015

CAPITAL ALLIANCE INVESTMENTS LIMITED

PRIVATE AND CONFIDENTIAL FOR THE INTENDED RECIPIENT ONLY

GLOBAL & LOCAL ECONOMIC INSIGHTS

Nov 2015

CAPITAL ALLIANCE INVESTMENTS LIMITEDPRIVATE AND CONFIDENTIAL 2

A POSSIBLE FED RATE HIKE IN DECEMBER MAY HINDER GLOBAL ECONOMIC GROWTH

CAPITAL ALLIANCE INVESTMENTS LIMITEDPRIVATE AND CONFIDENTIAL

US domestic consumption remains robust despite 3Q2015 GDP growth slowing to 1.5%

3

2.5%

0.1%

2.7%

1.8%

4.5%

3.5%

-2.1%

4.6%5.0%

2.2%

-0.7%

3.9%

1.5%

US quarterly GDP growth

Source: US BEA, The Economist & CAL Investments

3Q2015 GDP growth came lower at 1.5% YoY dragged down by companies cutting back on restocking warehouses to compensate for an inventory glut which was accumulated over the last few quarters and spending cuts in the energy sector. The inventory accumulated carved off 1.44% from 3Q2015 economic growth and is likely to fade in 4Q2015.

However, consumer spending which accounts for two-thirds of US GDP grew at 3.2% YoY during 3Q2015 after expanding at a 3.6% YoY growth in 2Q2015 driven by lower energy prices and an improving labour market.

+3.2% Consumer spending

+6.5% Spending on durable goods

+6.1% Housing construction

+1.9% Core Inflation


166

188

225

330

236

286

249

213

250

221

423

329

201

266

119

187

260245

223

136 142

271

Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15

The latest job numbers indicate that a US recovery is on the cards and a possible fed rate hike in Dec 2015

4

US Job creations (Thousands)

The job market recovered during October reaching a 10-month high of 271k of jobs created despite going through a sluggish phaseweighted down by the slowdown in the global economy. Unemployment rate fell to 5% in October from 5.1% in September, thelowest level since April 2008. The growing job creations are likely to drive wage inflation in the coming months which maypersuade the Fed to start raising interest rates.

Source: US Data & Statistics


Global traders believe that there is a 70% chance that the Fed will raise its benchmark rate from near zero in December

5

Source: Bloomberg

Implied percentage probability of a rate hike by end of 2015


15.8%

19.2%

17.5%

16.0%16.7% 17.3%

15.9%

9.5%

7.3%

4.7%

2.4%3.1% 2.7%

1.8%2.4%

4.2%

2.4%

4.0% 3.5%

1.3%

-2.7%-3.9%

However, contribution from net exports to GDP may decline as a stronger dollar weighs down manufacturing, trade and exports

6

US quarterly export growth YoY

US exports have declined first time since the economic recession in 2009

The US Dollar has appreciated against all major currencies during the last 12 months, making US products more expensive for foreign buyers. As a result, US exports have already started declining from 1Q2015. In 2013, exports accounted for 14% of US GDP while imports were 17% of GDP. Tightening of the monetary policy may lead to further appreciation of the USD and result in US net exports slowing down and affecting GDP growth

Source: US Data & Statistics


EU recovery at snail pace - QE taking effect

7

-0.3%

0.9%

1.6%

1.8%1.9%

2013 2014 2015E 2016E 2017E

European commission annual economic growth forecast

The reduction in oil prices combined with the QE program have boosted private consumption expenditure and has compensated for the lackluster external trade leading to sluggish economic recovery in the EU.

The slowdown in emerging markets, especially China which accounts for c.25% of EU exports may remain as an impediment to economic growth in 2016. However, the EU-19 economic recovery depends on the unprecedented stimulus that may be granted by the ECB

Given the slow economic recovery, the EU is likely to extend the €60bn/month QE program by at least another 6 months from Sep 2016 until ECB reaches its medium term inflation target of 2%.

-1.0%

-1.7%

-0.3%

0.4% 0.5%

1.1%

0.6%0.8%

1.0%

1.3%

1.6% 1.6%

EU-19 Quarterly GDP growth (YoY)

Source: European Commission


Slowing growth in China raises red flag for global economy

China accounted for c.30% of global growth in 2014. IMFlowered its global growth to 3.1% from its previous 3.3%estimate primarily due to the slowdown in the Chinaeconomy. The slowdown is mainly stemming from theindustrial and manufacturing sectors of China.

The impact is felt by emerging market countries which supplyraw material to China. Commodity producers like Brazil aresuffering as Chinese demand for its materials reduce while itseconomy rebalances itself from investment led growth toconsumption. Developed nations like Germany which exportsmachinery to China are also affected by the slowdown.

Only a significant pick-up in Chinese demand is likely to beadequate to balance metals markets such as copper andaluminum.

Excess capacity in manufacturing, a property marketslowdown and mounting local government debt are a fewfactors that have weighed on growth. Chinas has excesscapacity at present as investments have dropped sharply andglobal trade has stagnated.

8

China quarterly GDP growth

Source: The Economist & CAL Investments

7.7% 7.7%

7.4%7.5%

7.3% 7.3%

7.0% 7.0%6.9%

3Q2013 4Q2013 1Q2014 2Q2014 3Q2014 4Q2014 1Q2015 2Q2015 3Q2015

China industrial production, % MoM annualized


However, ‘consumer driven’ economic transition starting to materialize in China

9

Chinese economic growth has slowed down with the shift towards consumption from investments. The slowdown has negatively impacted global suppliers of raw materials and industrial equipment. However, business has picked up for companies that cater to the country’s growing upper-middle class which is evident through the 10.9% YoY retail sales growth witnessed in 3Q2015. Household consumption accounts for 40% of GDP.

Further, travel by Chinese households and golden-week expenditure also affirm that the economic transition is currently underway. Likelihood remains for further declines in exports and manufacturing as the transition intensifies.

YoY change in retail sales & industrial production

Air Traffic Movie box-office revenue

Movie theatres in China generated box-office revenue of ¥33bn for 9M2015, +53% YoY.

Source: The Economist & CAL Investments


COMMODITIES MAY SHOW MIXED SIGNALS IN 2016


US crude oil production rises 1% YoY despite a 60% YoY reduction in shale oil rigs

11

US Crude Oil Rig Count

US crude oil rig count fell to 572 in Nov 2015 which is the lowest level since June 2015

5000

5500

6000

6500

7000

7500

8000

8500

9000

9500

10000

Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Nov-15

Thsd

bar

rels

/day

Weekly US field production of crude oil

Lower oil prices have resulted in US shale oil rigs in operation plummeting 60% YoY as they found it challenging to breakeven at current prices. Oil prices usually reflect the number of oil rigs in operation with a 6 month time lag which means that more rigs could go out of business In the future.

US shale oil drillers are focusing on improving the productivity of their cost-efficient rigs which has resulted in higher crude oil production despite a 60% reduction in operational rigs. Saudi Arabia’s intention to curb US oil production failed due to the improving efficiencies of the oil rigs. Higher US crude oil output has contributed to the glut in global crude oil supply.

Source: EIA, Baker Hughes & CAL Investments


-2

-1

0

1

2

3

4

5

75

80

85

90

95

100

Q12010

Q32010

Q12011

Q32011

Q12012

Q32012

Q12013

Q32013

Q12014

Q32014

Q12015

Q32015

Q12016

Q32016

Implied stock change and balance (RHS)World production (LHS)World consumption (LHS)

Projection

Brent crude prices may hover around USD 50-55/barrel

12

Brent crude oil prices

40

60

80

100

120

140

160

Jan

-10

May

-10

Sep

-10

Jan

-11

May

-11

Sep

-11

Jan

-12

May

-12

Sep

-12

Jan

-13

May

-13

Sep

-13

Jan

-14

May

-14

Sep

-14

Jan

-15

May

-15

Sep

-15

USD

/Bar

rel

Global oil production, consumption & Δ in inventory (Mn barrels/day)

2013 2014 2015E 2016E 2020E

108.56 98.89 53.82 56.24 80

EIA forecast

Growth in global demand has risen to a 5-yr high of c.2 mn barrels/day, with India sprinting to its fastest pace of consumption in more than a decade and personal consumption in terms of travel picking up due to lower oil prices. EIA anticipates global crude oil production to continue to outpace consumption in 2016. However, it expects the inventory build up to slowdown on the back of lower US and Canada oil production in 2016. The IEA also predicts that a sluggish recovery in demand and decline in supply would yield a price of $80 /bbl in 2020.

CALI believes that Brent crude may hover around USD 50-55/barrel in 2016 as a result of Iran contributing 500-700kbarrels per day post-sanction removal and due to the expectation that US production is likely to remain flat for 2016.

Source: EIA & CAL Investments


China’s transition into a consumer driven economy hurts commodity prices

13

During the peak of its growth phase, China consumed c.50%of the world's copper, 54% of aluminum, 50% of nickel and45% of steel production. Decelerating growth in China andBeijing’s move to build a more consumer focusedeconomy have beaten commodity prices down in 2015.

Given the dull economic outlook for China, it remains unlikelythat metal prices will see a major recovery in 2016. However,a marginal recovery in oil prices may drive production costshigher and moderately increase metal prices in 2016.

The effects of the El-Nino weather phenomenon has starteddamaging food crops via excess rain and limited rainfall acrossthe globe. Excessive downpours in Brazil has led to lowersugar harvest while the drought in Thailand has already hurtrice production. El Nino is likely to lead to an increase in rice,coffee, sugar, maize, cocoa and palm oil prices during end2015 and early 2016.

Since most commodities are USD denominated, a possibleUSD appreciation due to a fed rate hike may makecommodities expensive in local currency terms and reducedemand for the commodity.

The Economist commodity-price index change

-0.4%

0.5%

-1.6% -1.0%-1.9% -2.2%

-17.2%

-12.3%

-23.6%

-15.7%

-26.6%

-3.9%

MoM % YoY % Source: The Economist & CAL Investments


Gold prices hit a 5-year low on ‘Fed rollercoaster’

14

800

1000

1200

1400

1600

1800

2000

Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

USD

/Oz

Gold prices fell to a 5-year low of USD1074/Oz in November as investors feareda possible US fed rate hike.

The price drop transpired despite a 33%YoY jump in demand for gold in 3Q2015which was led by a 70% YoY growth inChinese investment, the largest consumerof the precious metal. China investorsbought gold as a safe haven investment toprotect them against the stock marketcrash and further Yuan depreciation.

If fed hikes interest rates in December,gold prices may fall further as investorsmove into income-generating assetsrelative to the non-yielding yellow metal.

A possible appreciation of the USD due tothe rate hike may further hurt gold prices.Analysts expect gold prices to crash asmuch as USD 800/Oz if the fed raises ratesin December.

Global gold prices

Source: Bloomberg


FISCAL PRESSURE TO BE THE KEY CHALLENGE FOR 2016


SL raised USD 3.5bn via Treasury bills, bonds & SLDBs during 11M2015, +64% higher than what was raised in 2014…

16

Total amount of T-bills, T-bonds and SLDB outstanding as at 11Nov2015 was LKR 4.9Tn. The govt raised USD 3.5bn in net borrowingsvia t-bills, t-bonds and SLDBs which was 64% higher than what was raised in 2014.

However, the net borrowings raised via sovereign bonds and SLDBs increased to USD 2.6bn in 11M2015 from USD 1.3bn in 2014.

Net amount raised via T-bills, bonds & SLDBs (USD bn)

2.1

3.5

2014 11M2015

USD

bn

+64%

Net amount raised via USD sovereign & SLDBs (USD bn)

Source: CBSL, Bloomberg & CAL Investments

1.3

2.6

2014 11M2015U

SD b

n


…as the budget deficit surpassed the preliminary 2015 target within the first 8 month of 2015

17

Budget deficit

499

540

470

480

490

500

510

520

530

540

550

Initial 2015 target 8M2015 (Actual)

LKR

bn Budget deficit from Jan-Aug 2015 was LKR 41bn

higher than the government’s target of LKR 499bn for 2015

Lower than expected revenue realization and higher than anticipated interest payments were the main reasons for the higher budget deficit.

Govt’s interest payments for 8M2015 was LKR 384bn vs. LKR 425bn estimated for the full year.

Source: SL Treasury


Likelihood remains for the 2015 budget deficit to close at 6.8%-6.9% vs. 5.7% in 2014

18

Annual budget deficit (LKR mn) based on new GDP methodology

448 489 516

591

750 800

6.2%

5.6%5.4%

5.7%

6.8%

6.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

(100)

100

300

500

700

900

1,100

1,300

1,500

2011 2012 2013 2014 2015E 2016E

LKR

mn

The 6.8% budget deficit for 2015 is on the back of a cut in public infrastructure spending

In Feb 2015, budget allocation for public infrastructure spending was cut from LKR 576bn to LKR 399mn.

Source: CBSL & CAL Investments


The govt is facing severe fiscal pressure as 100%+ of its revenue is spent on debt servicing at present

19

87%89%

85%88%

115%

98%

93%

100%

106%

92%

117%

Debt servicing cost (Principal + interest cost) as a percentage of government revenue

Source: CBSL, Treasury & CAL Investments

Sri Lanka’s debt service cost as a percentage of government revenue rose to 117% in 8M2015. Over the last 5 years, debt service cost has remained close to 100%.

The SL govt needs to raise taxes substantially to reduce its budget deficit and decrease dependence on debt financing.


SL’s access to multilateral & bilateral loans have reduced over time

20

Loans from multilateral lending agencies (e.g. ADB, IMF) have reduced from 48% of foreign funding in 2005 to 29% in 2014 while bilateral loans with other countries have reduced from 45% in 2005 to 25% in 2014. Japan accounts for 52% of bilateral funding as at 2014 while India accounts for 11%.

If the SL government makes structural reforms to increase tax revenue to acceptable levels, likelihood remains that SL could tap the multilateral lending agencies such as IMF and ADB for low-cost financing

Domestic debt, 60%

Foreign debt, 40%

USD 56bn

Outstanding government debt as at 30 Jun 2015 Foreign debt breakdown 2005 & 2014

48%

29%

45%

25%

7%

46%

2005 2014

Multilateral loans Bilateral loans Financial market lending

Source: CBSL, Treasury & CAL Investments


SL corporate taxes are not the lowest in the region (28% vs. avg. 25%)

21

17% 17%

20% 20% 20%

25% 25% 25%

28% 28%30% 30%

35% 35%

Corporate tax rates of regional peers

Avg. 25%

Source: World Bank


Govt needs to broaden the tax base - Despite higher corporate taxation, contribution from direct taxes are only c.17%

22

Personal income tax, 1%

Corporate Income tax, 8%

PAYE, 2%Economic Service

charge, 1%

Tax on interest income, 6%

Domestic VAT, 23%

Excise Tax , 21%

NBT, 4%Telecommunication

Levy , 3%

Motor Vehicles Taxes & other, 1%

Taxes on External trade, 20%

Non Tax Revenue, 12%

2014 Government

Revenue

Direct Tax Revenue

Indirect Tax Revenue

Non Tax Revenue

71%

12%17%

Direct taxes only account for 17% of the government revenue despite corporate taxes remaining high at 28%. Govt requires to computerize tax filings and track down on tax evaders to broaden its tax base.

However, given that the government has an immediate requirement to increase revenue, it is likely that the govt may resolve to further increase indirect taxes to swiftly materialize the funding requirement

Source: CBSL & Treasury


70,993

85,192

94,657

104,123

118,322

132,520 137,253

141,986

30,000

50,000

70,000

90,000

110,000

130,000

150,000

15% 18% 20% 22% 25% 28% 29% 30%

A 1% upward revision in corporate taxes will only contribute LKR 4.7bn in incremental revenue*

23

+4.7bn

*If corporate taxes are increased 1%, the government will only be able to raise LKR 4.7bn in additional revenue assuming that the tax base will not increase due to the tax revision.

Current

LKR

bn

Source: SL Treasury, CBSL & CAL Investments

Corporate tax income at different taxation rates %


251,946 279,940

307,934 335,928

363,921 391,915

419,909

503,891

9% 10% 11% 12% 13% 14% 15% 18%

However, a 1% increase in indirect tax such as VAT may have a higher impact with LKR 28bn in incremental government revenue*

24

Value added Tax revenue at different taxation rates %

+28bn

Source: SL Treasury, CBSL & CAL Investments

* Imposing a higher indirect tax will raise 6x of the amount that can be raised via a direct tax increase. The government is more likely to raise VAT or any other indirect tax to generate the funding shortfall within a short span of time.

Current


1H2015 GDP growth was primarily driven by private consumption

25

Quarterly volume growth of FMCG categories covered by Nielson's Retail Audit (YoY)

-17%

-2%-1%

2%3% 3%

10% 10%9%

7%

Source: Nielson, CSE & CAL Investments

Real GDP growth (new methodology) during 2Q2015 grew 6.7% YoY on the back of renewed consumer spending driven by lowerinflation and government budget reliefs despite a cut in infrastructure spending.

According to the Nielson survey, quarterly FMCG volume grew 9% YoY in 1Q2015 and 7% YoY in 2Q2015 indicating the extent ofconsumer spending during 1H2015.

3.6%

5.9%

4.0%

0.5% 0.7%

1.9%

4.7%

9.9%

6.0%6.7%

Sri Lanka quarterly GDP growth (Base = 2010)


Probable indirect tax increases and inflation to hurt private consumption and economic growth during 2016

26

We believe that economic growth is likely to slowdown in 2016 due to possible tax hikes in the budget, an LKR 7% depreciationand higher inflation affecting consumer spending in 2016. However, we anticipate public infrastructure spending to recover to2014 levels and GDP growth to be 6.5% in 2015 and 5.5% in 2016.

SL annual GDP growth forecast

3.6%

5.9%

4.0%

0.5% 0.7%

1.9%

4.7%

9.9%

6.0%6.7%

Sri Lanka quarterly GDP growth (Base = 2010)

8.4%9.1%

3.4%

4.5%

6.5%

5.5%

2011 2012 2013 2014 2015E 2016E



INTEREST RATE DIRECTION TO BE DRIVEN BY GOVERNMENT’S FUNDING STRATEGY IN 2016


5,843

11,894

-2,418-3,850

17,663

-222 -2,906 -628

-8,040

-31,095

-2,462-2,611 -1,313-2,475

2,9622,568

-9,153

-17,287

-31,342

-25,765

-42,162

-22,076

-7,768

(50,000)

(40,000)

(30,000)

(20,000)

(10,000)

-

10,000

20,000

30,000

LKR

mn

Foreigners exited their bond positions during May-Oct 2015 anticipating an LKR depreciation

28

Foreign holdings in SL government bills and bonds have declined to 7.2% in Nov 2015from 12% in Jan 2015. Foreigners have sold LKR 154bn worth of bills and bonds YTD

Net foreign inflows/ outflows in the government securities market (LKR mn)

Source: CBSL


Post- LKR depreciation, SL bonds are attractive for foreign investors

29

Comparative 10-yr govt. bond yields

9.6%

8.9% 8.8%

7.6%

7.0%

4.1%3.7%

2.6%

Sri Lanka Pakistan Indonesia India Vietnam Malaysia Philippines Thailand

Source: Trading Economics

With the LKR depreciating 7% YTD and provided no further significant depreciation, the yields offered by SL govt bonds are attractive to foreign investors compared to the yields offered by regional peers


SL 5-year bond yield premiums have risen 160bps YoY

30

400

450

500

550

600

650

700

750

800

850

900

Source: Bloomberg

Bond yield premiums above the US 5-year govt bond


The CBSL printed upto c.LKR 230bn in currency to pay off its fiscal debt and bond maturities during 10M2015

31

CBSL holding in government securities (LKR bn)

0

50

100

150

200

250

01.0

1.2

015

12.0

1.2

015

22.0

1.2

015

30.0

1.2

015

11.0

2.2

015

20.0

2.2

015

02.0

3.2

015

11.0

3.2

015

19.0

3.2

015

27.0

3.2

015

07.0

4.2

015

17.0

4.2

015

27.0

4.2

015

07.0

5.2

015

15.0

5.2

015

25.0

5.2

015

03.0

6.2

015

11.0

6.2

015

19.0

6.2

015

29.0

6.2

015

08.0

7.2

015

16.0

7.2

015

24.0

7.2

015

04.0

8.2

015

12.0

8.2

015

20.0

8.2

015

28.0

8.2

015

07.0

9.2

015

15.0

9.2

015

23.0

9.2

015

02.1

0.2

015

12.1

0.2

015

20.1

0.2

015

29.1

0.2

015

06.1

1.2

015

17.1

1.2

015

The central bank printed money and purchased government bonds to make settlements for the bond maturities and budget deficit, creating BOP pressure in the process

Consequent to raising the USD sovereign bond, the Central Bank sterilized c.USD 1bn out of the USD 1.5bn proceeds raised due to which the proceeds were not available in the system to drive domestic credit.


CB sterilizes the USD 330mn SLDB taking liquidity out of the system and replacing it with Central Bank ‘s holdings in government bonds

Central Bank printed money to repay rupee bonds


Market excess liquidity has risen to LKR 140bn as the govtprinted currency and pumped liquidity into the market

32

Market liquidity (LKR bn)


0

20

40

60

80

100

120

140

160

12.1

2.2

014

22.1

2.2

014

31.1

2.2

014

09.0

1.2

015

21.0

1.2

015

29.0

1.2

015

10.0

2.2

015

19.0

2.2

015

27.0

2.2

015

10.0

3.2

015

18.0

3.2

015

26.0

3.2

015

06.0

4.2

015

16.0

4.2

015

24.0

4.2

015

06.0

5.2

015

14.0

5.2

015

22.0

5.2

015

01.0

6.2

015

10.0

6.2

015

18.0

6.2

015

26.0

6.2

015

07.0

7.2

015

15.0

7.2

015

23.0

7.2

015

03.0

8.2

015

11.0

8.2

015

19.0

8.2

015

27.0

8.2

015

04.0

9.2

015

14.0

9.2

015

22.0

9.2

015

01.1

0.2

015

09.1

0.2

015

19.1

0.2

015

28.1

0.2

015

05.1

1.2

015

16.1

1.2

015

LKR

bn

Govt printing money to pay bond maturities & fund budget deficit

Foreigners exiting T-bond positions

A surge in imports & net foreign outflows from the bond market

Central Bank sterilizing c.USD 1bn out of the USD 1.5bn proceeds raised via the sovereign bond

Central Bank sterilizing the USD 650mn sovereign bond proceeds


The SL government has LKR 1.2tn (USD 8.3bn) in T-bills, T-bonds and sovereign bond maturities in 2016

33

Cumulative treasury bills, bonds and sovereign bond maturities


-

50

100

150

200

250

Jan

-16

Mar

-16

May

-16

Jul-

16

Sep

-16

No

v-1

6

Jan

-17

Mar

-17

May

-17

Jul-

17

Sep

-17

No

v-1

7

Jan

-18

Mar

-18

May

-18

Jul-

18

Sep

-18

No

v-1

8

Jan

-19

Mar

-19

May

-19

Jul-

19

Sep

-19

No

v-1

9

Jan

-20

Mar

-20

May

-20

Jul-

20

Sep

-20

No

v-2

0

LKR

bn

LKR

17

8 b

n

LKR

21

8b

n

LKR

44

1 b

n

LKR

34

0 b

n


For the rest of 2015, treasury yields are unlikely to move up as the USD bond, SLDB and one-off taxes ease funding pressure

34

New taxes imposed LKR mn

Super gains taxes 50,000

Mansion tax 1,000

Special levy on casino industry 5,000

License fee for vehicle importers 375

Migrant taxes 100

Bars and Taverns Levy 1,000

Mobile Telephone Operator Levy 1,250

Satellite Locations Levy 2,000

Dedicated Sports Channel Levy 1,000

Total 61,725

Funds raised by the government in Oct 2015

Sovereign bond raised - USD 1.5bn

T-bills & T-bonds raised - USD 1.2bn

SLDBs raised - USD 330mn

Proceeds from one-off taxes* - USD 420mn

Total amount raised - USD 3.5bn

One-off taxes* passed in parliament in Oct 2015

The USD 3.5bn will be utilized to make payments for treasury maturities during the Oct-Dec 2015 time period which amounts to USD 2.6bn (LKR 379bn) and fund the budget deficit over the period (USD 1.2bn)* which means the government is unlikely to borrow large amounts until the end of this year.

Source: CBSL, Bloomberg & CAL Investments*USD 1.2bn for Oct-Dec 2015 was derived from the average budget deficit/month (LKR 60bn) for 8M2015


However, the USD 8.3bn bond maturities and budget deficit (USD 5.6bn) funding requirement may drive interest rates in 2016

35

Our base case view is that treasury yields will move c.50-150bps upwards during 2016 due to:

• Severe pressure in terms of raising USD 14bn to finance maturities and fiscal deficit• Inflation edging up to 4-5% in 2016• The government finding it challenging to raise USD borrowings from the global market as US

Fed starts increasing rates in Dec 2015

Best case scenario would be treasury yields remaining flat or edging up a maximum of 50bps during 2015 due to:

• The government successfully raising USD sovereign bonds from the global market and reducing dependence on the local market

• Substantial tax increases in the government budget reducing budget deficit burden



Inflation rose to 1.8% in Oct 2015 moving away from the deflationary territory

21%

1.7%

-1%

0%

1%

2%

3%

4%

5%

6%

0%

5%

10%

15%

20%

25%

Mar

-14

Ap

r-1

4

May

-14

Jun

-14

Jul-

14

Au

g-1

4

Sep

-14

Oct

-14

No

v-1

4

Dec

-14

Jan

-15

Feb

-15

Mar

-15

Ap

r-1

5

May

-15

Jun

-15

Jul-

15

Au

g-1

5

Sep

-15

Oct

-15Private Sector Credit growth (LHS) Inflation YoY (RHS)


Inflation rose to 1.8% YoY in October from a 0.3% deflation in September while core inflation* rose to 4.4% YoY from 4.2% in September

Private sector credit growth rose to 21.3% YoY in Aug 2015 on the back of robust consumer spending. vehicles.

With vehicle costs rising and LTV on vehicles being reduced to 70%, vehicle imports are likely to slowdown. Higher inflation and lower consumer spending are likely to keep private sector credit lower in 2015.

Private sector credit growth & CCPI Inflation YoY

*Core inflation excludes certain items that have volatile price movements such as food and energy prices.


Inflation will kick in from Nov 2015 driven by supply-side dynamics

37

ItemWeek ending

12-Nov-2015A month ago MoM %

LKR/kg LKR/kg

Rice

Samba 98 88.8 10%

Kekulu (Red) 70 69.2 1%

Vegetables

Beans 280 169 66%

Cabbage 200 78 156%

Carrots 230 111 107%

Tomatoes 180 109 65%

Pumpkins 60 64 -6%

Snake Gourd 140 103 36%

Brinjals 140 86 63%

Ash-Plantains 100 92 9%

Other Foods

Red-Onions (Local) 175 142 23%

Big-Onions (Local) 135 136 -1%

Potatoes (N'Eliya) 160 132 21%

Dried Chilies (Imported) 350 344 2%

Dhal (Indian) 190 184 3%

Eggs (Red) 13 14.8 -12%

Coconut (Each) 55 50.2 10%

Fish

Kelawalla 600 536 12%

Balaya 360 298 21%

Salaya 180 150 20%

Paraw (Small) 520 474 10%

Simple average 29%

Average retail food prices – Pettah market

Food & Non alchoholic

beverages, 48%

Clothing and footwear, 4%

Housing, water, electrics, gas &

other fuels, 18%

Furnishing, HH Equipment &

routine maintenance of

house, 3%

Health , 6%

Transport, 12%

Communication, 2%

Recreation and culture, 1% Education, 3%

Miscellaneous Goods and

Services, 2%

CCPI Inflation basket as at Oct 2015

The CCPI avg. household expenditure was LKR 51k as at Oct 2015.Vegetables and seafood account for c.25% of the F&B segment of whichprices have increased on avg. 20% MoM. If we assume that USDdenominated costs such as clothing, household equipment and healthexpenditure increases 6% MoM due the LKR depreciation while otherexpenses remain the same compared to Oct-2015, inflation for Novemberwould come in at 3.1% YoY

Source: CBSL, Census & Statistics & CAL Investments


6.5% 6.5%

7.0%

7.3%

7.5%

6.0%

6.2%

6.4%

6.6%

6.8%

7.0%

7.2%

7.4%

7.6%

HNB Sampath Bank CommercialBank

NDB Seylan Bank

Bank deposit rates on avg. have risen 65bps since March 2015 as treasury securities edged up 70bps…

38

1-yr bank deposit rates (gross)

Increase/decrease in deposit rates from March 2015

1-yr treasury bill rates

6.4%

6.3% 6.3%

6.5%

7.0%

7.2%

7.1%

Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15

0.0%

0.5%

0.7%

1.0% 1.0%

HNB NDB Seylan Bank Sampath Bank CommercialBank Source: CBSL & bank websites


…and a recovery in private sector credit growth absorbed liquidity

39

Loan growth of listed banks vs. Liquidity ratios Sep 2014 & Sep 2015

55%48%

27% 25% 24% 24%21% 19%

17%

22% 22%23%

22% 22%

27%28%

27%

23%24%25%

27%

25% 25%

34%

30%

34%

27%

0%

5%

10%

15%

20%

25%

30%

35%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

UBC PABC HNB SAMP NTB COMB SEYB DFCC NDB

Loan growth YoY (LHS) Liqudity ratio - Sep 2015 (RHS) Liquidity Ratio - Sep 2014 (RHS)Source: Bank quarterly statements


Private sector credit growth may start slowing down in 2016 on the back of the recent custom duty revisions and possible taxes in the budget

40

Annual Private sector credit growth

7%

-6%

25%

35%

18%

7%9%

23%

13%

2008 2009 2010 2011 2012 2013 2014 2015E 2016E

CALI expects private sector credit growth to close at 22-23% in 2015E and reduce to 12-13% YoY in 2016E as consumption slows down.

We expect loans given out towards consumer durables, vehicles, credit cards and personal housing to slowdown in 2016.

Source: Bank quarterly statements


Currency may hold at LKR 142-145/USD in 2016


LKR has depreciated against most currencies in 2015

42

85

90

95

100

105

110

USD/LKR EUR/LKR INR/LKR CNY/LKR GBP/LKR JPY/LKR

Base =Jan 2015

The LKR has depreciated 7% YTD against the USD

Source: Oanda


Weak Trade balance – Lower oil bill negated by a spree in consumer spending and lower exports

43

Increase/decrease in Jan-Aug imports 2014 to 2015 (USD mn)

-1659.2

125.6 128.8

297.1 317.5

793.8

Higher expenditure on vehicles and consumer goods wasnegated by a 48% reduction in the fuel bill stemming fromlower oil prices and higher coal power generation which ledto the total imports remaining flat for 8M2015

Trade balance Jan – Aug 2014 & 2015

(5,156)

(5,412)

Jan-Aug 2014 Jan-Aug 2015

USD

mn

SL’s exports during 8M2015 fell 3.4% YoY on the back of lower teaand rubber exports resulting in the 8M2015 trade gap widening toUSD 5.4bn from USD 5.2bn in 8M2015.

A delay in depreciating the LKR currency also reduced thecompetitiveness of SL goods in the global market during 8M2015 ascompetitor nations had already depreciated their currencies.

Further, pressure was exerted on the BOP due to outflows in the govtbond and equity market, subdued FDIs and low USD denominatedborrowings obtained by the government during 8M2015

Source: CBSL


Vehicle imports to decline as new custom valuation, a 70% LTV restriction, a 7% LKR depreciation and possible duty hikes in the budget take effect

44

28k

23k 27k 29k

27k 28k

34k 32k

41k

51k 50k

42k

67k

48k 51k

57k

62k

52k

64k

56k

Jan Feb Mar Apr May Jun Jul Aug Sep Oct

2014 2015

Vehicle registrations per month Vehicle registrations already started to decline from October, contradicting the usual upward trend in vehicle sales before the budget

New vehicle registrations may decline similar to what was witnessed in 2012 where vehicle registrations declined to 397k and 327k in 2013 as a result of the import duty hike in 2013 and a c.13% LKR depreciation

Source: Department of motor vehicles


A fall in consumer spending and lower thermal power generation may further reduce import bill in 2016

45

58%

37%

68%

12%

26%

29%

2%2%

2%

28%35%

0%

2013 2014 14-Nov-15

Hydro power Coal NCRE Thermal oil

SL power generation by typeNielson Business Confidence Index

The 7% YTD LKR depreciation has already resulted in imports becoming expensive for SL customers. With inflation starting to kick in from November and possible indirect tax increases in the budget being passed on to the consumer, we expect consumer spending to significantly slowdown during 1H2016 which may drastically reduce the import bill.

At present, 68% of the electricity requirement is generated via hydro power due to the higher rainfall this quarter. With SL securing a contract to procure coal at concessionary rates from South Africa, the energy bill is likely to reduce further in 2016.

Source: LMD, CEB & CAL Investments

120

130

140

150

160

170

180

190

200

210

Jan

-14

Feb

-14

Mar

-14

Ap

r-1

4

May

-14

Jun

-14

Jul-

14

Au

g-1

4

Sep

-14

Oct

-14

No

v-1

4

Dec

-14

Jan

-15

Feb

-15

Mar

-15

Ap

r-1

5

May

-15

Jun

-15

Jul-

15

Au

g-1

5

Sep

-15

Oct

-15

The Nielson BCI fell 46 points MoM in Oct 2015 indicating future slowdown in business activity


However, SL needs to diversify its export earnings to sustain long term BOP position and economic growth

46

22.3%22.6%23.6%23.7%29.1%

68.4%75.0%79.6%

86.4%

187.6%

Exports as a percentage of GDP - 2014

39.0

22.3

20

22

24

26

28

30

32

34

36

38

40

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

SL exports as a percentage of GDP (2000-2014)

SL should diversify its export earnings into manufacturing, assembly operations and Knowledge Process Outsourcing (KPO) similar to the transition that the South East Asian countries went through in the 1990s without entirely depending on apparel and commodityexports.

Source: CBSL


Declining USD reserves indicate that CBSL may be vulnerable in case the LKR is under severe depreciation pressure

47

7.1 7.0

7.5

8.08.3

8.1

8.98.7

9.29.0

9.2

8.8 8.8

8.38.2

7.3 7.2

6.8

7.5

6.8

7.5

6.8

6.5

6.8

6.5

5

6

6

7

7

8

8

9

9

10

Oct

-13

No

v-1

3

Dec

-13

Jan

-14

Feb

-14

Mar

-14

Ap

r-1

4

May

-14

Jun

-14

Jul-

14

Au

g-1

4

Sep

-14

Oct

-14

No

v-1

4

Dec

-14

Jan

-15

Feb

-15

Mar

-15

Ap

r-1

5

May

-15

Jun

-15

Jul-

15

Au

g-1

5

Sep

-15

Oct

-15

USD

bn

CBSL gross official reserves (USD bn)

SL’s USD reserves have declined to USD 6.5bn, one of the lowest reserve positions in the last 2 years

This also includes a USD 1.1bn dollar swap with RBI. Excluding this, the reserve position is at USD 5.4bn

Source: CBSL


We believe that LKR may stabilize at LKR 142-145/USD in 2016

A lower import bill due to rising inflation and higher taxation

curbing consumer imports

Improving competitiveness of exports due to the LKR depreciation

An overreaction of the LKR depreciation in 2015

Government tapping global markets to raise USD bonds in 2016 &

FDIs starting to materialize

However, if the Fed continuously raises rates during 2016, possibility remains for the USD to depreciate to c.LKR 148/USD

48


PROSPECTS FOR LONG TERM EQUITY MARKET GROWTH REMAINS PROMISING


SL equity market has witnessed heavy foreign selling YTD (USD 27mn)Foreign inflows/outflows to equity markets (USD mn)

0.9

10.5 10.5

6.35.3

-20.0

-6.3

-32.4

1.3

-3.7

0.9

Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15

Source: CSE


6,700

6,800

6,900

7,000

7,100

7,200

7,300

7,400

7,500

7,600

7,700

Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15

ASPI down 4.3% on the back of fiscal pressure, a depreciating LKR and an uptick in interest rates

51

ASPI

Run up to the presidential election

Imposition of a super gains tax in the interim budget

A recovery in corporate earnings and anticipation of a UNF victory

Rising treasury yields, LKR depreciation and anticipation of a negative budget

Treasury bond scandal

Political uncertainty running up to the general elections

Source: CSE


Sri Lanka still a cheaper destination compared to regional peers

52

TTM PER (x)

19.5%

31.0% 33.0%

45.3%

60.0%

75.3%

104.7%

Market cap as a % of GDP

Source: Bloomberg & World Bank

9.8x11.4x 11.7x

17.5x 18.1x19.6x 20.2x

25.3x


9M2015 overall market earnings subdued due to forex losses. However, FMCG & manufacturing sectors were driven by consumption and lower commodity prices

53

Source: CSE & CAL Investments

-4%

18%

-16%

4%

15%

4%

21%

44%

21%

3Q2013

4Q2013

1Q2014

2Q2014

3Q2014

4Q2014

1Q2015

2Q2015 3Q2015

Overall market earnings growth YoY

-30%

6%

-2%

22%

51%

9%

17% 11%

-3%3Q2013

4Q2013

1Q2014

2Q2014

3Q2014

4Q2014

1Q2015

2Q2015

3Q2015

Manufacturing sector earnings growth YoY

Banking & Finance earnings growth YoY

-7%

1%7%

32%

56%

35%

42%

31%

6%

3Q 20134Q 20131Q 20142Q 20143Q 20144Q 20141Q 20152Q 20153Q 2015

Food & Beverage sector earnings growth YoY

-4%

18%

-16%

4%

15%

4%

21%

29%34%

3Q2013

4Q2013

1Q2014

2Q2014

3Q2014

4Q2014

1Q2015

2Q2015

3Q2015

3Q2015 market earnings declined 3% YoY primarily due to a 7% LKR depreciation resulting in forex losses


We expect the long term prospects for the equity market to be promising due to:

Source: CSE & CAL Investments

The SL market being relatively cheaper compared to regional peers

and attracting foreign investors

A growing middle income population driving consumption and

corporate earnings in the medium term

Foreign direct investments flowing into the country post-structural

reforms

However, the market may witness a temporary downturn as corporate earnings slowdown with the possible tax revisions in the budget

global & local economic insights - nov 2015

Economy & Finance