Fiscal deficit target remains challenging

We see three reasons for a slower-than-expected recovery as the economy adjusts to bold central bank policy measures aimed at addressing growing imbalances: (1) more fiscal consolidation is required; (2) inflation is elevated, limiting room for near-term policy easing; and (3) the recovery in Sri Lanka’s main trading partners, the EU and US, remains slow. That said, Sri Lanka looks well positioned to achieve slightly faster growth in 2013 than 2012‟s 6.5% given that the policy bias is shifting towards supporting growth.

Lowered GDP growth forecast

The Ministry of Finance is confident that GDP growth in the 7.0-7.5% range is achievable given 15% projected growth in money supply. We are less optimistic for several reasons. Inflation is high, public debt remains elevated at c.80% of GDP, and tax revenue collection is less than 11.5% of GDP (among the lowest in Asia) as a consequence of falling imports and tax administration issues. The government relied heavily on capital spending cuts and delays in cash payments to achieve its fiscal deficit target of 6.2% of GDP in 2012; this is a concern, as lower capital spending may stifle growth. The 2013 deficit target of 5.8% of GDP will be challenging to meet unless significant revenue-generating reforms are implemented. In light of these concerns, we lower our 2013 GDP growth forecast to 6.7% from 7.2%; this also reflects the fact that 2012 was likely 6.5%, below our most recent 6.8% forecast.

Revised timing of expected 50bps rate cut

CPI inflation has been at or above 9% for the past six months, partly on account of adverse weather conditions and related food-price shocks. We expect inflation to moderate from Q2-2013 onwards, largely due to base effects and improved food supply. This should counter potential fuel price rises expected in the coming months. The slowing of credit and domestic demand growth to a more sustainable pace has created some room for monetary easing. However, high inflation continues to limit this near-term. We expect further rate cuts in 2013 to stimulate growth (following a 25bps cut in December 2012), taking the repurchase rate to 7.00%. However, we now expect a 50bps rate cut in Q3-2013, versus Q2-2013 previously, amid concerns that further policy easing could fuel inflationary pressures.

BoP surplus to support LKR gains

Prolonged weakness in the global economy continues to undermine external demand; however, the balance of payments (BoP) is likely to remain in surplus in 2013. The central bank expects a USD 500mn BoP surplus, marginally higher than the USD100mn surplus achieved in 2012, as lower imports narrow the trade deficit further and higher tourism earnings and workers‟ remittances continue to offset weak export demand. The current account should continue to improve marginally in 2013, as oil prices are relatively stable and energy imports show signs of a structural decline on increased hydropower generation.

The capital account should also pose limited risk to the Sri Lankan rupee (LKR). The government has signalled that it does not intend to issue a sovereign bond in 2013, and the authorities are unlikely to support another year of LKR depreciation in light of debt dynamics. As such, we are constructive on the LKR, forecasting USD-LKR at 126.5 by end-2013.

At the conclusion of its Article IV consultation with Sri Lanka in February 2013, the IMF said that the government still needs to implement significant reforms such as improving tax administration, reducing losses at state-owned enterprises, and promoting exports to strengthen revenue streams. This may have contributed to Sri Lanka not obtaining a fresh USD 1bn IMF loan to provide budget support for infrastructure projects. The key risk arising from not getting the new loan is that Sri Lanka‟s FX reserves may again dwindle due to higher import spending.

Market outlook

Given still-high CPI inflation and the reduced likelihood of policy rate cuts before Q3-2013, we remain Neutral on T-bond duration. Although the surprise rate cut in December pushed the 5Y T-bonds to a one-year high in mid-January, the gains were not sustained. Since then, the 5Y T-bond yield has increased by c.40bps, bear steepening the yield curve. We expect demand and supply in the T-bond market to be balanced, and look to shift our duration stance to Overweight once CPI inflation eases.


(This is an extract from a recently released report by Standard Chartered)