Sri Lanka, with international reserves amounting to less than US$ 7 billion, and other emerging markets with weaker fundamentals amid market volatility could face risks in the face of the US Federal Reserve announcing plans to cut its stimulus programme later this year.
The rupee has already fallen sharply in recent weeks after foreign investors holding Treasury bonds sold down their holdings. The Central Bank is resorting to moral suasion, selective intervention and withholding data in a bid to calm the forex market.
"Many emerging markets have flexible exchange-rate regimes that can take some of the strain from volatile capital flows, provide countries with more scope for setting interest rates to suit domestic conditions and may support growth through gains in competitiveness," Fitch Ratings said in a recent report.
"Some EMs (emerging markets) are more exposed than others to volatile capital flows and higher interest rates if the Fed’s exit from ultra-loose monetary policy proves to be bumpy," Fitch said in its "Sovereign Review and Outlook: 2013 Mid-Year Update" released earlier this week.
"Uncertain process of the Fed’s exit from unprecedentedly loose policy settings is likely to generate periodic bouts of market volatility," Fitch said.
According to Fitch, "most vulnerable to a potentially turbulent Fed exit" are emerging markets with large external financing requirements, low foreign reserves, high levels of leverage, strong inflows of portfolio money and rising credit, and weak economic framework and fundamentals—evidenced by low credit ratings.
Fitch warned of repercussions in capital and currency markets. "Market volatility creates its own problems and can feed on itself. Losses can trigger fund redemptions and forced selling," the report read.
Short-term rise in inflation, reducing purchasing power and increasing political pressures, could also kick-in due to "sharp exchange-rate depreciations," it added.
"Fluctuations in interest rates, credit availability and asset prices, as well as uncertainty, may deter investment," it noted.
Hungary, Jamaica, Lebanon, Mongolia, Turkey and Ukraine have at least three indicators that show up red on Fitch’s heat-map "signaling risky or stretched levels."
Countries with at least two red indicators include: China (both related to the banking sector), Indonesia, Poland, Egypt (both related to public finances), Sri Lanka and Dominican Republic (both relate to external finances).
Sri Lanka has a red indicator for external liquidity and government debt maturities. For 2013, Fitch has indicated that the gross external financing needs of the country amounted to 80.7 percent of reserves. The current account deficit and net foreign direct investments are at -3.7 percent of GDP. Net external debt as a percentage of GDP was 38.1 percent of GDP.
Meanwhile, Argentina, South Africa, Romania, Vietnam, Tunisia, Ghana, Serbia and El Salvador are countries with several yellow and in some cases red indicators pointing to "lesser potential stress."
Fitch, however, clarified that it "does not anticipate a widespread wave of EM crises," as improved credit fundamentals over the past decade made these economies "more resilient to this type of global liquidity shock than in past."
Loose monetary policy in the US has benefited emerging markets, but the Fed’s pronouncements on easing its $85-billion bond buying stimulus dubbed quantitative easing has resulted in "a broad market sell-off and increased volatility since the middle of May."
Fitch, however, maintained "the comments should not have been a great surprise and reflect more upbeat US growth prospects" that in the end would benefit most emerging markets.
Sri Lanka’s reserve position is low compared to its peers and is made up mostly of debt.
Gross official reserves grew by US$ 169 million during the month of April 2013 to US$ 6,858 million, up 2.52 percent from US$ 6,689 million in March, data released by the Central Bank showed. The reserves were lower by US$ 19 million since reaching US$ 6,877 million as at end December 2012. As at end December 2012, debt and short term inflows amount to 95 percent of reserves. Total government borrowing alone, at US$ 5,256.9 million, amounted to around 76.44 percent of reserves, as at end December 2012.
Sovereign ratings agency Moody’s earlier this month downgraded Sri Lanka outlook from ‘Positive’ to ‘Stable’. "The action was prompted by: 1) The stabilization in the external payments position, following the sizable loss of foreign reserves in 2011, but without enough improvement to support a positive rating action at this time; and 2) The pause in the decline in the government’s very high debt burden, as ongoing large deficits impede a reduction that would be credit positive," Moody’s said.
GMA Newsonline reported that the Philippines could face lesser risks than other emerging market economies. The Philippines does not have any yellow nor red indicators, Fitch’s heat map showed. The Philippines has international reserves of $81.64 billion as of end-June 2013, with monetary authorities expecting to end the year with a record $87 billion. The Philippines were given investment grade rating by Fitch and Standard & Poor’s, while Japan Credit Rating Agency affirmed its investment grade rating for the Southeast Asian nation.