* Policy rates to remain unchanged, growth to slowdown
* CBSL FDI target maybe stretched, BOP surplus less than hoped for
* Exporters keeping away from forex market exacerbating pressure on exchange rate
The most recent Standard Charted Bank ‘On the Ground’ series of research reports says the rupee is expected to appreciate from the third quarter of this year and policy interest rates kept steady with credit growth easing as many banks are not lending to large corporates to finance factory expansions and other capacity initiatives.
"We remain optimistic on the LKR over the medium term and expect sustained appreciation from late Q3-Q4 onwards. While stable policy rates are a positive for the bond market, we have raised our T-bond yield forecasts for the remainder of 2012 due to fiscal-slippage concerns, hardening inflation and tight banking-system liquidity, which in our view are three factors that are likely to maintain upward pressure on the yield curve," the research report, authored by authored by Samantha Amerasinghe, Priyanka Kishore and Nagaraj Kulkarni, said.
Excerpts of the report follows:
Inflation edges higher but the economy is slowing down…
In its policy statement, the CBSL emphasised that "growth in private-sector credit in April in absolute terms slowed to LKR 18.7bn (a 31.7% y/y decline in absolute terms), well below the average monthly growth of LKR 51.8bn in Q1-2012"; it was the lowest reading in almost two years.
Anecdotal evidence shows that the 18% cap on bank lending has impacted industry; for instance, banks have been refusing loan requests from large corporates for factory expansion and other capacity-building initiatives.
Central bank data also shows that lending to the construction, trade and manufacturing sectors (as a percentage of total lending) declined by 2ppt each as at end-March 2012 versus the same period in 2011.
In addition, while export growth has slowed considerably (trade data, just released, shows a 9.2% dip in April 2012 exports, following the double-digit decline in March), it has been accompanied by a similar slowdown in import growth due to the CBSL’s policy measures to curb imports. As a consequence, the trade deficit has actually improved to USD 0.76bn from USD 1.1bn in November 2011.
On the inflation front, the central bank takes comfort from having kept inflation in single digits for the past three years. That said, it has been edging higher since February, when the CBSL implemented fuel-price hikes. Subsequently, inflation spiked in May to 7.0% y/y due to upward revisions to cement, gas and milk powder prices. We now forecast annual average inflation at 7.2% (higher than our previous estimate of 6.7% and the central bank’s 7.0% projection) as we have adjusted our inflation trajectory to take into account the stronger-than-expected May inflation print (our forecast was at 6.1%).
In our view, the expected uptrend in inflation can be primarily attributed to the lower base in 2011 and is not due to demand-side pressures or imported inflation, as it is clear that import-related credit has come down and is expected to fall further in the months ahead in response to the central bank’s tight policy measures. Furthermore, the recent decline in international oil prices and the easing of global commodity price pressures should help contain inflation.
Hence, we believe the CBSL is more concerned about the expected further export slowdown than the current uptrend in inflation, given that domestic demand is already showing signs of cooling down.
In a Reuter’s interview on 14 June, the Treasury Secretary indicated that further signs of weakness in export demand in the coming months may prompt the authorities to ease monetary policy to support growth. However, in light of elevated inflation pressures, we think there is little likelihood of policy-rate cuts and believe the central bank will keep rates on hold.
Capital inflows hold the key to the BoP surplus …
Sri Lanka’s balance of payments (BoP) deficit narrowed significantly to USD 251mn in Q1-2012 from USD 1.1bn in Q4-2011. This is largely due to a lower trade deficit; improved surpluses in services and current transfers due to sustained strong remittance inflows (up 16.6% y/y to USD 1.96bn) and tourism earnings (up 25.7% y/y) for the January to April period; and stronger inflows into the capital account.
Foreign direct investment (FDI) recorded inflows of USD 220mn during Q1-2012 compared with USD 197mn over the same period last year. We expect the capital account to further benefit from: (1) disbursement of the final USD 430mn tranche of the IMF Stand-By Arrangement (SBA) in July; (2) the upcoming sovereign bond issuance, which is likely to be between USD 500mn and USD 1bn; and (3) reports that further IMF funding in the form of a USD 500mn security arrangement is likely upon the completion of the SBA.
We look for a BoP surplus of USD 0.9bn in 2012 from a USD 1.06bn deficit in 2011, somewhat lower than the central bank’s USD 1.25bn projection. The authorities have targeted exports of USD 11.7bn in 2012, imports of USD 20.9bn and FDI of USD 2bn. We are concerned that export earnings and capital inflows may fall short of the authorities’ targets if global risk sentiment deteriorates.
Remittance inflows and tourism earnings (with the Twenty-20 cricket tournament scheduled for September 2012) in H2 should remain buoyant. With FDI inflows at only USD 313mn at end-May, the CBSL’s USD 2bn target appears to be a stretch. Our FDI forecast is lower, at USD 1.5bn. The authorities’ main concern is to ensure that their projected capital inflows materialise, hence a pro-growth policy stance would send out the right signal to investors, given the adverse global outlook.
Growth to moderate from Q2-2012 onwards …
The central bank has indicated that the slower recovery in the EU and US, Sri Lanka?s key export markets, poses downside risks to its 7.2% growth target. However, in its 13 June policy statement, the CBSL expressed that this target is well within reach. This confidence likely stems from the expected robust Q1-2012 GDP performance. The Q1-2012 GDP print (released on 18 June) was at 7.9% y/y (even higher than our bullish 7.5% estimate), driven mainly by construction (a 17.5% y/y increase) and tourism (up 25.7% y/y, as mentioned above).
Growth was broad-based across all key sectors, with the agricultural sector recording 11.5% y/y growth, largely due to the low base and floods in Q1-2011, which affected supply. The industrial sector grew by 10.8%, while services (which account for 60% of GDP) increased by 5.8%. A strong showing from the construction sector was anticipated prior to the release, as available data on cement production, a good proxy for construction sector activity, increased by 74.9% y/y in Q1-2012. We expect growth to moderate from Q2-2012 onwards on the back of lower export growth and slower domestic demand.
LKR – Local positives versus global challenges …
After gaining 15.2% in Q1-2012 (trough-to-peak), USD-LKR has traded largely sideways in Q2, albeit in a wide range. In the short term, several factors cloud the LKR outlook:
* The global backdrop remains challenging due to European sovereign risks and the recent downturn in global economic data. Though the Greek election outcome was market friendly, divisive Greek politics have limited the positive impact on risk appetite. That said, we note that the one-month correlation between daily returns in USD-LKR and the DXY index is almost negligible, at 0.06. Thus, domestic US dollar (USD) imbalances rather than broader risk sentiment are a more significant driver of the LKR.
* Sri Lanka’s BoP deficit narrowed significantly to USD 251mn in Q1-2012 from USD 1.1bn in Q4-2011. As the CBSL noted in its 13 June policy statement, policy measures to limit import demand have had a significant effect. Import growth fell to -3.3% y/y in April 2012 from +77.9% y/y 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 USD shortage. However, this could change swiftly if sentiment improves in favour of the LKR due to a combination of policy measures and a revival of risk appetite.
As such, the risks appear quite balanced for the LKR into quarter-end and a pullback towards our Q2-end target of 128 cannot be ruled out in the coming days, especially if import demand remains muted. Also, the substantial depreciation in the currency year-to-date is likely to provide a floor below exports at some point, thereby leading to a narrower trade deficit.
Thus, we are optimistic on the LKR over the medium term and expect sustained appreciation from late Q3-Q4 onwards. Key to this view are the disbursement of the final USD 430mn tranche of the SBA facility, the upcoming sovereign bond issuance and reports that further IMF funding in the form of a USD 500mn security arrangement is likely upon the completion of the SBA. Together, these should return Sri Lanka’s BoP to a USD 0.9bn surplus in 2012 from a USD 1.06bn deficit in 2011," Standard Chartered Bank said.