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Reality check of Sri Lanka’s FDI and emerging role of financial investors

7 May 2015 03:21 am - 0     - {{hitsCtrl.values.hits}}


According to newly released economic data, Sri Lanka has attracted foreign direct investments (FDI) amounting to US $ 1,685 million in 2014 – a 21 percent increase from 2013, but below the US $ 2 billion target set by the government. Sri Lanka consistently failed to reach FDI targets in recent years although the overall FDI trend remains positive. FDI, as a percentage of gross domestic product (GDP) improved to 2.2 percent in 2014 compared to 2.0 percent in 2013. 

Need for analysing composition of FDIs 
When analysing FDI, it is important to analyse the composition or nature of FDI. As a frontier country aiming to avoid the middle-income trap, Sri Lanka needs quality FDI comprising of long-term risk capital. It is also important that Sri Lanka attract new foreign funds coming into the country. The chart highlights the overall trend and composition of FDI during post-2009 period. As evident from the chart, the share of borrowings or bank loans included in FDI has increased steadily during the last four years. The net foreign capital inflows in the form of equity and debt capital (from investors) have not increased in line with the overall FDI growth.   

Large share of FDI are bank loans
Out of the US $ 1,685 million FDI recorded in 2014, 33 percent or US $ 564 million represents (actual) foreign capital inflow to the economy. This includes (net) capital inflows in the form of equity and debt from promoters of various ventures/projects. Reinvestment of retained earnings (internally generated capital) has accounted for a further 22 percent of FDI or US $ 381 million. Increase in reinvestments by existing firms is a positive trend.    
Borrowings or bank loans have accounted for a significant 44 percent of FDI in 2014, compared to 34 percent in 2013.  Bank borrowings included in FDI have increased by 55 percent from last year to reach US $ 740 million in 2014. A large share of bank borrowing appears to be loans given by international banking units of local commercial banks. Also, increase in borrowings and reinvestments represent mostly expansions by the existing businesses and do not represent new business start-ups. 

Financial investors emerge as main risk capital provider 
New equity investments or net inflow of risk capital during 2014 was US $ 137 million compared to US $ 23 million in 2013. Equity investments, which typically represent investments, new ventures/projects, accounted for 8.1 percent of total FDI during 2014, compared to mere 1.7 percent in 2013. According to Jupiter Capital Partners’ estimates, private equity investors or long-term financial investors accounted for at least US $ 110 million of primary equity investments in 2014. A major share of these investments was channelled into existing financial services firms (including US $ 88 million to Union Bank by TPG Capital). It is also noteworthy that the majority of primary foreign equity purchases have been in public listed companies. Table 2 highlights estimated equity inflows from financial investors during the last three years.  

Need to focus on non-tradable sector
Another notable trend seen in Sri Lanka’s FDI is the high concentration of FDIs in non-tradable sectors such as infrastructure development. Manufacturing industries have attracted only 20 percent of FDI in 2014, compared to 25 percent in 2013. Investments in non-tradable sectors are unlikely to help Sri Lanka avoid falling into middle-income trap. However, investments in non-tradable sectors such as infrastructure are also important as they support development of the tradable sector indirectly. But we must not forget the fact that no country has reached high income status without going through industrialization and it is imperative that Sri Lanka focus more on attracting FDIs into manufacturing industries. 

Potential of financial investors as risk 
capital investors?

Sri Lanka faces many challenges in attracting FDIs. Foreign firms seem to be reluctant to come and set up operations in Sri Lanka due to many internal and external reasons. As evident from the FDI trends during the last three years, Sri Lanka has the potential to attract more financial investors to supplement slow growth of FDIs from foreign firms. Financial investors could be encouraged to provide risk capital to local businesses, which will yield far greater long-term benefits to the country than foreign firms starting operations in Sri Lanka.  
However, there are challenges in matching Sri Lanka’s industrial opportunities with global financial risk capital providers. The starting point would be to develop an efficient capital market eco-system integrated not only with the global capital market but also with local entrepreneurs at all levels. 
The validity of the argument that foreign firms bring in technology and best industry practices (with FDI) is seen eroding because today best of technologies are available to purchase and best industry practices have become commonly used across countries. In such an environment, financial investors are better aligned to support companies acquire technology and introduce best practices because financial investors’ objective is long-term sustainability and success of the local investee firm, not the long-term benefit of a foreign firm, as in the case of most non-financial FDI investors. 

(Indika Hettiarachchi, the Founder/Managing Director of Jupiter Capital Partners, a Sri Lanka-based private equity advisory firm, could be contacted at [email protected])

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