Via Emerging Frontiers blog, an interesting look at Sri Lanka:

Since Sri Lanka’s 26-year civil war against the Tamil Tigers came to an end in 2009, the South Asian nation of 20 million has experienced impressive growth due to a rise in tourism and its strategic position along one of the busiest international shipping lanes in the world. The US $64 billion economy is propelled by tourism, remittances, tea, textiles, and agriculture. Sri Lanka’s GDP, which grew at 8% in 2010 and 8.3% in 2011, slowed down to 6.5% in 2012 due to the country’s balance of payments predicament and the sluggish performance of the global economy. However, 7.5% growth is projected in 2013 and last year’s contraction will be ameliorated as tourist arrivals surge, large-scale infrastructure and port projects near completion, and Western demand for Sri Lanka’s exports strengthens. Matching the country’s solid GDP growth are its improvements in corporate governance. Sri Lanka was ranked as the second most improved country in the world in ease of doing business in the World Bank’s Doing Business 2013 report, the first time in seven years that a South Asian economy gained such an accolade.

Tourism is a key component of Sri Lanka’s economy, with one million visitors arriving in 2012, an 18% increase from the previous year. The island was named New York Times’ #1 destination in 2010, one of National Geographic’s “Best Trips for 2012”, and the #1 country in Lonely Planet’s “Best in Travel 2013” guide. Tourist arrivals from China in 2012 grew by 58% YoY, evidencing the colossal market that the Sri Lankan tourism industry is just beginning to tap into. The tourism sector’s promising outlook bodes well for complementary industries like construction, hotels, and leisure and should drive sustained growth in the Sri Lankan economy.

With the end of the civil war, infrastructure and port development have become focus areas for the Colombo government as it seeks to rebuild the country and tout Sri Lanka as an international maritime hub. The state is planning to spend US $3.7 billion in 2013 to revamp the country’s damaged infrastructure, a 20% increase from last year. Reconstruction has especially focused on the Northern and Eastern Provinces, which suffered the most from decades of heavy fighting. Sri Lanka’s proximity to prime international shipping lanes suggests the island could become a hotspot for global maritime trade. The Port of Colombo is one of the busiest ports in the world and a US $1.2 billion expansion project should be completed by the end of this year, growing container handling capacity by 300% and providing increased economies of scale that will benefit both importers and exporters. In addition to expanding the Port of Colombo, Sri Lanka is also constructing a billion-dollar, Chinese-financed deep-sea port in Hambantota. Once the project is fully completed, the Port of Hambantota will be the largest harbor built on land in the 21st century and will tap into the major east-west shipping lanes used by 200-300 vessels daily that pass 19 km to the south. The shipping industry currently contributes 6-8% to Sri Lanka’s GDP and this should easily double in the next five years due to the port expansion projects.

Remittances sent home by Sri Lankans working abroad are the largest source of foreign exchange earnings for the country and a vital contributor to the economy. US $6 billion was sent home in 2012 by the 1.7 million Sri Lankans working overseas, accounting for 10% of the country’s GDP and marking a 17% increase from the previous year. However, the nation’s migrant workers have become a contentious issue in recent months after a Sri Lankan maid was beheaded in Saudi Arabia despite international condemnation – prompting the Sri Lankan government to recall its envoy to the country. This sensitive event could have major implications for the future inflow of remittances, as the majority of Sri Lanka’s migrant laborers work as maids in the Gulf.

One impressive pillar of Sri Lanka’s post-conflict recovery has been the performance of its stock market, the Colombo Stock Exchange (CSE). The CSE was formally established in 1985 and has a market capitalization of US $17.6 billion. After being heralded by Bloomberg as the World’s Best Performing Stock Market in 2010, the bourse faced difficulties in 2012. The market lost 7.1% during the year, primarily a function of the first half of 2012 when it fell 18.6%, as tight monetary and fiscal policy led to the anticipation of an economic slowdown. The CSE performed much better in Q3 and Q4 as the Sri Lankan rupee strengthened against the dollar and many listed companies experienced better earnings than projected. International interest in the Colombo Stock Exchange piqued in 2012, with foreign investors contributing to 34% of the market’s turnover. Sri Lanka recorded a record inflow of foreign capital last year of US $303.8 million.

The best-performing sector on the CSE in 2012 was the construction and engineering sector, which rose 73% on the year largely due to the IPO of Access Engineering Limited (AEL), one of the largest firms in Sri Lanka’s booming construction industry. The sector’s impressive growth seems likely to continue as lower interest rates will increase access to capital, kickstarting more construction projects and contributing to the gain of stocks in related industries such as cement, cables, and tiles.

The food, beverage, and tobacco sector, which makes up 18% of the bourse’s market capitalization, also surged in 2012, gaining 32% on the year. This strong performance should carry into 2013 as the growing middle-class fuels domestic consumption and the number of tourist arrivals continues to grow.

2012 saw six IPOs on the Colombo Stock Exchange from companies in the tourism, energy, construction, and financial services sectors. In an attempt to boost the number of listings on the CSE this year, a proposal has been put forward in the 2013 budget to give a 3-year, half tax holiday for new companies that list before December 2013 and maintain at least 20% of their shares with the public. Such a move would help Sri Lanka’s bourse by introducing more liquidity and decreasing volatility. Several state-owned enterprises are considering listing in 2013, but further details have not yet been disclosed.

The outlook for the Colombo Stock Exchange in 2013 is positive, as a relaxed monetary policy will lower interest rates, prompting more investors to turn to Sri Lanka’s bourse to seek higher returns. Increased capital inflow from foreign investors should also buttress strong performance this year. Expansion in high-growth industries like tourism and infrastructure will be reflected in Sri Lanka’s capital markets and stocks with exposure to these sectors are likely to benefit.

Certain questions will loom over Sri Lanka’s future growth and development, however. The recent decision to impeach Chief Justice Shirani Bandaranayake was strongly condemned by the international community, and Washington warned that the move would damage post-war reconciliation and hinder foreign investment. Navenetham Pillay, the United Nations High Commissioner for Human Rights, called Bandaranayake’s removal a “calamitous setback for the rule of law in Sri Lanka” and admonished Sri Lanka that it would face serious repercussions from the UN. Many critics see the dismissal as a strategic move to consolidate power – President Mahinda Rajapaksa’s current administration includes three of his brothers and the impeached judge had made verdicts against the ruling government.

Another major challenge for Sri Lanka is how best to cope with the difficulties caused by US sanctions levied against Iran. The Persian pariah state is a key trading partner and the Sri Lankan economy has been hit hard by the sanctions. Up until a year ago, Iran supplied Sri Lanka with 93% of its crude oil. Sri Lanka’s sole refinery, which was built to refine only Iranian light crude and will require major changes to process crude from other sources, was temporarily shut down last year due to the curtailment of Iranian imports. The island nation has since shifted to importing expensive refined oil from other Middle Eastern producers and crude oil from Iraq, Oman, and the UAE. As a result of the sanctions, oil prices have skyrocketed in Sri Lanka, with kerosene rising 49% and the country’s oil imports for 2012 hitting a record US $6 billion, a 30% increase from the previous year. This enormous expenditure has strained Sri Lanka’s foreign reserves and sparked protests over increased energy costs. Circumventing the sanctions, however, would surely mar Sri Lanka’s relations with the US, its largest trading partner. The sanctions have also had negative ramifications for exports – Iran is Sri Lanka’s second largest export market for tea, a core commodity that accounts for 12% of GDP.

Fortunately, Sri Lanka has extensive hydropower generation facilities and the Treasury Secretary recently stated that up to half of the country’s power is now hydroelectric and that reservoirs are full after heavy rains in the latter part of 2012. Now that the civil war has ended, oil exploration is underway with the hopes that domestic discovery could ease Sri Lanka’s massive petroleum import bill. Cairn India recently began the second phase of its oil exploration program in Sri Lanka and will announce the commercial prospects of the project by next year.

Despite concerns over political freedom and rising energy costs, Sri Lanka remains a compelling investment destination and one of Asia’s most promising up-and-coming markets. The island’s post-war development progress is remarkable and its continued stability will help Sri Lanka move beyond middle-income status and solidify its pertinent position as a trade and transport mecca. Sri Lanka’s economic expansion will be mirrored in the country’s equity market, and foreign investor interest coupled with rising domestic consumption will generate prolonged growth in the Colombo Stock Exchange.