The Sri Lankan rupee has fallen by some 17 percent against the US dollar since the beginning of this year, as a credit bubble crashed in to the balance of payments sending a currency peg diving from 110 to 132 so far this year.
“We remain optimistic on the rupee over the medium term and expect sustained appreciation from late quarter three- quarter four onwards,” Colombo-based Standard Chartered Bank said in a research note to clients on Friday.
The bank said its view was driven by Sri Lanka drawing down the final 430 million dollar tranche from the International Monetary Fund’s 2.6 billion dollar facility in the coming weeks and the government plans to raise up to a billion dollars in sovereign debt this year.
“Together, these should return Sri Lanka’s balance of payments to a 900 million dollar surplus in 2012 from a 1.06 billion dollar deficit in 2011,” the note said.
Sri Lanka’s balance of payment deficit narrowed significantly to 251 million dollars during the first quarter of this year, from 1.1 billion dollars in the fourth quarter of last year.
The narrow deficit came as the central bank raised import duties and placed ceilings on banks’ credit to dampen import demand.
Import growth fell to 3.3 percent year-on-year in in April 2012 from +77.9 percent year-on-year in November 2011. However, a sharper slowdown in exports due to weak global growth has limited the positive impact on the trade deficit.
“Anecdotal evidence indicates that Sri Lankan exporters have been largely sidelined from the spot market, exacerbating the onshore US dollar shortage. However, this could change swiftly if sentiment improves in favour of the rupee due to a combination of policy measures and a revival of risk appetite,” it said.
For the second consecutive month, the central bank in June left its key policy rates at 7.75 percent for the repurchase rate and 9.75 percent for the repurchase rate.
“We feel the central bank’s policy bias is likely to shift back to growth from inflation given the uncertain global outlook and weaker demand from the EU and US, Sri Lanka’s key export markets,” the paper noted.
Bond markets view stable policy rates positively. However, there are some signs of concern, Standard Chartered Bank said.
“We believe fiscal-slippage fears, hardening inflation and tight banking-system liquidity are likely to maintain upward pressure on the yield curve. On the back of these, we have raised our T-bond yield forecasts for the remainder of 2012.”
From January to May, Sri Lanka issued 201 billion rupees worth of treasury bonds, which accounts for some 68 percent of the budgeted domestic market borrowing requirement for 2012. This is higher than about 21 percent raised during the same period in 2011.
If treasury bill issues of about 118 billion rupees is added, then the net market borrowing already exceeds budgeted domestic market borrowing for the whole of 2012(about 294 billion rupees), according to the report.
“Such front-loaded borrowing has strengthened expectations of fiscal slippage and an extension of market borrowing beyond the budgeted amount,” the authors noted.
While a successful sovereign bond issuance might provide some respite during third quarter of this year, supply concerns are likely to persist for the remainder of 2012.
Moreover, headline inflation seems to have reversed its trajectory, the authors believe hardening inflation would widen the term premia on treasury bonds.
Banking-system liquidity, which has been in deficit since the beginning of 2012, has pushed the overnight borrowing cost (call money rate) to a three-year high of 10.28 percent.
If the Central Bank of Sri Lanka maintains its liquidity stance for the remainder of 2012 then elevated funding costs would also contribute to a hardening of yields, the report said.
With supply likely to be the key driver of the rates market in the remainder of 2012, the shape of the yield curve will depend on the issuance profile.
“If the government continues its historical (and 2012 year-to-date) issuance pattern of extending duration, then we expect the yield curve to continue its bear-steepening trend,” the report added.