Financial Times

Fuel price hike to hit corporate earnings
Corporate earnings in the next quarter of the financial year are expected to come down as a result of the steep increase in fuel prices, following the government's decision to slash subsidies, and its ripple effects across the economy.

The anticipated rise in interest rates and electricity tariffs would also affect the profitability of listed companies as they would increase company finance and production costs, stock market analysts said.

Inflation, which had already picked up even before the government's recent decision to slash subsidies and the consequent price hikes, is seen rising further towards the end of the year. Danushka Samarasinghe, research analyst at SC Securities, said the fuel price hikes were "inevitable" given the soaring price of crude oil and the government's inability to go on subsidising domestic fuel prices at previous levels.

"It was simply a matter of time. The oil price increases are beyond the control of the government," he said. The soaring crude oil prices put pressure on the rupee as the increased cost of fuel imports resulted in a widening of the trade deficit, leading to speculation of a further depreciation.

Hasitha Premaratne, head of research at HNB Stockbrokers, said it was obvious the government could not continue with the subsidies. Had the government done so it would have not been able to keep to the targeted budget deficit of 8.5 percent of GDP. Even now, HNB Stockbrokers projects a slightly higher budget deficit.

Finance Minister Sarath Amunugama's recent announcement that the government intends to prune subsidies contradicts his previous statements promising relief to consumers and the fullest support to develop local industry.

The fuel price hikes are likely to trigger a chain reaction, as they would result in prices increases across the board, fuelling inflation and interest rate increases. Higher interest rates would increase corporate finance costs and affect their profitability, Premaratne of HNB Stockbrokers said.

"With the increase in inflation, company cost structures would also increase." While costs would go up immediately, it would take time to pass on the increased costs to customers. This would affect company revenues and have a negative impact on their bottom line.

HNB Stockbrokers has projected corporate earnings growth of around 14.1 percent this financial year. Premaratne said investors should not forget that corporate earnings grew by a healthy 39 percent in the 2003 financial year.

He said the stock market went up too fast in recent weeks and had got overheated. It was now coming down and the correction would better reflect the fundamental values of listed firms.

Samarasinghe of SC Securities said companies in the manufacturing, services such as shipping and transportation, and the hotels sectors would bear the brunt of the effects of the fuel price hikes.

"Soon, we expect to see an electricity price increase. That would increase all production costs and corporate margins would drop." Companies in exports such as plantations and garments would initially benefit from the depreciation of the rupee.

However, Samarasinghe pointed out that this benefit would be offset by the higher costs of imported inputs. This means the depreciation of the rupee would not help exporters as much as is generally believed.

Premaratne said that among import firms, those in the automobile industry and importing milk powder such as Nestle and Lanka Milk Food, would be affected as they would have to bear part of the costs increases.

While the government may be unable to control the price of imported milk, it could try to lessen the burden on consumers with more investment to improve the domestic livestock industry and reduce dependence on milk imports, said Samarasinghe.

"The government should be a bit more lenient towards the agriculture sector," Samarasinghe said. "If it has no alternative other than to remove subsidies, then it should at least try to streamline distribution and minimise losses of agricultural produce during transportation. If it has to remove subsidies it can give some benefits in other ways."

Some of the health care firms could also be affected a little as they import drugs and equipment. Samarasinghe said he expects the rupee to stabilize at around 104 or 105 to the dollar as the currency had strengthened against the dollar during the time of the previous regime.

The interest rate and inflations differentials with Sri Lanka's major trading partners had indicated that theoretically the rupee should have come down to the current level.

Imposing foreign exchange controls was not realistic and would be disadvantageous to the economy in the long term. The image it would create of a return to the era of controls could deter foreign investors.

Meanwhile, National Chamber of Exporters (NCE) president Kingsley Bernard said exporters opposed exchange controls because of the negative effects on business.

"Exchange controls generally have negative implications for export growth as our operations need to be very dynamic," Bernard said. Exporters were not bringing back their export proceeds because they use part of the money to buy their requirements of raw materials abroad.

"If they bring the money back here, they have to send it out again to buy raw materials abroad," Bernard explained. "Then they suffer an exchange loss at a time the rupee is depreciating. This is a major reason for exporters to not bring back export earnings.

This has been the practice for several years but got highlighted recently because of heavy demand for dollars which outstripped supply. "The exchange rate is decided according to demand and supply," explained Bernard. "Now demand for dollars is high. So when exporters are also not bringing in dollars then the supply becomes less. As a result, the rate goes up and the rupee gets devalued. That's why the issue cropped up."

The government has said it had discussed re-imposing exchange controls or restrictions to compel exporters to bring back their foreign exchange earnings. One possible restriction that had been used before and could be tried again was a rule to force exporters to remit their proceeds within a specified time period.

Bernard also said exporters don't think subsidies are "the best method of developing a country." The government should re-examine the issue of subsidies seriously and use them selectively where they provide a worthwhile gain, Bernard said. "If the returns from subsidies are less than what the government spends, then they are not worthwhile," he said.

Bernard said exporters do need subsidies to help them compete in international markets. "When the government looks at subsidies it must see whether the subsidies are giving a good return - see what is the input-output relationship. If the returns are greater than what is spent on subsidies, then they are productive." The government should strive to improve efficiencies in production before cutting subsidies, Bernard said.

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