Dwindling foreign reserves, increased money printing to exert pressure on rupee

• Official foreign reserves forecast to decline to US $ 5.5-6bn by year-end
• Govt. likely to face around US $ 1.5bn gap in funds to service foreign currency debt
• Sri Lanka has nearly US $ 6bn foreign currency debt servicing this year
• CBSL had exhausted US $ 174.30mn in defending rupee in March
• Morgan Stanley estimates Sri Lanka faces US $ 4.4bn worth of net drains on its foreign exchange reserves, over next 12 months

By Nishel Fernando 
Sri Lanka’s rupee is expected to feel the pressure from the dwindling official foreign reserves combined with the impacts from the increased money printing towards the latter part of the year, when the demand rebounds from the current sluggish levels. 

First Capital Research predicted that Sri Lanka’s official foreign reserves are likely to decline to the US $ 5.5-6 billion range, at the end of the year, from US $7.2 billion in April.

Speaking to Mirror Business, First Capital Head of Research Dimantha Mathew noted that the government is likely to face around US $ 1.5 billion gap in funds, to service foreign currency-denominated debt, which would be settled in utilising the funds in foreign exchange reserves. 

Consequently, he expects the pressure on the rupee to increase from the latter part of the year, with the dwindling reserves, combined with the effects coming from the increased money printing seen so far during the year.

The New York-based multinational investment banker and financial services company, Morgan Stanley, in a recent report expressed concerns over the recent uptick in money printing by the Central Bank of Sri Lanka (CBSL).
It pointed out that the CBSL’s security portfolio increased by over Rs.200 billion versus the rise in government debt of around Rs.285 billion, since the start of March, up to April 20. 

“This was primarily to inject liquidity into the system but ultimately, if these operations are not unwound, it may put pressure on the currency and as we highlighted above, FX depreciation could in turn impact the leverage metrics,” Morgan Stanley cautioned. 

Further, the CBSL had exhausted US $ 174.30 million in defending the rupee in March, following the sharp depreciation of the currency against the US dollar, in the month.  

First Capital Research estimates that Sri Lanka has a nearly US $ 6 billion foreign currency debt servicing obligation in 2020.

With around US $ 1.5 billion raised from various sources for the record debt servicing this year, First Capital expects that the government would be able to raise another US $ 3 billion from bilateral loans, currency swaps and funding agencies such as the IMF.  

However, Mathew said that Sri Lanka would still face a US $ 1.5 billion shortage, which will have to be settled drawing funds from the country’s foreign reserves. 

Similarly, Morgan Stanley also noted that Sri Lanka faces US $ 4.4 billion worth of net drains on its foreign exchange reserves, over the next 12 months.  

Further, it noted that the country has US $ 544 million of short swap positions coming due as well.

“Together with US $ 2-2.5 billion worth of current account deficit, the total external funding requirements stand at US $ 7-7.5 billion. Taking into account FDI, the funding needs should stand at around US $ 6.5 billion,” the investment bank stated. 

The IMF and Sri Lankan government are currently negotiating to reach an agreement to replace the existing Extended Fund Facility (EFF) arrangement, which is set to expire next month, with a rapid financing instrument, following a request from the government. 

Mathew pointed out that it would be crucial for Sri Lanka to have the rapid financing instrument as part of the existing EFF, to delay the repayments of the EFF, which starts from this year.

“It has to be definitely part of the existing EFF; otherwise Sri Lanka will have to start paying back the EFF while the new funds are coming in. Hence, it is likely to be an extended programme of the EFF,” he said. 

Meanwhile, the yields of Sri Lanka’s international sovereign bonds (ISB) saw a sharp increase in the secondary market, over the last week.  

The yields of US $ 1 billion ISB, which is set to mature this October, rose to 44.42 percent last week, from 39.23 percent in the previous week, reflecting the default fears of international investors.  

The bond was issued for the 6.25 percent coupon rate. All ISBs maturing before or in 2025 were trading with yields above 20 percent. 

Mathew opined that Sri Lanka is unlikely to issue any ISBs for another year, given the high cost of financing. 
“That’s completely out for about a year,” he said. 

Fitch Rating last month downgraded Sri Lanka’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) to ‘B-’ with negative outlook. 

In its report, Morgan Stanley stated that they now prefer Pakistan ISBs over Sri Lanka’s in the Asian context and Ghana over Sri Lanka in the global context, mainly due to Sri Lanka’s worsening fiscal environment. 

“Sri Lanka spreads are currently trading at over 1,000bp, generally considered a stress threshold in the markets. From that perspective, cash prices are also important to look at. Looking at low cash prices for long-end bonds could imply at first glance that they are attractive but upon looking at the peer group comparison, the attractiveness is less obvious,” Morgan Stanley elaborated. 

However, the investment bank believes that Sri Lanka’s external funding sources should be sufficient to meet the funding requirement in the near term.

In addition, if the debt suspension by G-20 countries is to be extended to Sri Lanka, the investment bank pointed out that the country could yield debt suspension worth US $ 1.2 billion in 2020, providing great relief and liquidity.