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SCB bullish on Sri Lanka s economy
Thursday, 30 June 2011 - 10:56 AM SL Time
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SCB bullish on Sri Lanka s economy
* Lack of govt. transparency, private sector participation affecting investment
* Fiscal consolidation continues
* Rupee appreciation gains momentum
* Inflation seen softening, policy rates to be stable & no need for hike
Standard Chartered Bank s Asia Focus periodical themed `Inflation in Asia: Close to the peak, but no quick easing` says inflationary pressures have began to ease in Sri Lanka, expected to reach 7.4 percent by the year end with interest rates expected to remain stable. This will lead to an easing of the growth-inflation dynamic but without vibrant foreign direct investments, expected economic growth would be unlikely.
This is in contrast to another global bank s view on inflation. HSBC believes inflationary pressures would increase along with growth, resulting in a tightening of policy interest rates.
However, Standard Chartered Bank is cautious about demand-driven inflation and believes it could emerge in 2012. The bank forecasts a balance of payments surplus and believes rupee appreciation against the dollar would gain momentum in the month s ahead.
Under the title `Sri Lanka:Striking the right balance`, Standard Chartered Bank was bullish on Sri Lanka s macroeconomic prospects, including the fiscal performance, but was concerned about matters of governance and transparency. The full text of its report follows:
No signs of overheating
`Q1-2011 GDP data will likely show a slowdown in growth due to flood-related damage, but there is no cause for alarm, as leading indicators suggest that this was temporary. Growth remains strong across all key sectors, and a rebound is expected from Q2 onwards. Private-sector credit growth is inching higher and touched 30.1 percent y/y in March, but from a low base. Hence, some deceleration in credit growth is expected in the coming months. Sustaining a higher growth trajectory will require a more conducive environment for foreign investment inflows, which surprised on the upside in Q1 at USD 236 million but may still fall well below the authorities full-year target of USD 1 billion.
Inflation risks recede
`Inflation pressures have started to ease, and the growth-inflation dynamic should therefore pose less of a challenge to policy makers in H2-2011. We expect inflation to trend lower for the rest of the year due to supply-side improvements, and as commodity prices stabilise. Inflation moderated to 8.8 percent y/y in May from 9.8 percent in April. We expect inflation to average 7.2 percent in Q3-2011 and to drop further to 6.0 percent in Q4, largely due to the June rebasing of the 2002 CCPI index to a new index based on 2006-07 consumer surveys. The weightings of the food and fuel components will be altered, with that of food falling to 41 percent from 46.7 percent and fuel raised to 23.7 percent from 18.3 percent. We maintain our full-year inflation forecast of 7.4 percent.
`The risk posed by surplus liquidity in the system has receded with the 1ppt statutory reserve ratio (SRR) hike. Banking-system liquidity remains high, at around Rs. 60 billion, but we believe it will become less of a threat. Inflation continues to slow, and the economy shows little sign of overheating due to spare capacity. However, due to the strong growth momentum reflected in the latest trade data, we remain cautious on the possibility that demand-driven inflationary pressures will emerge in 2012. We have therefore marginally raised our inflation forecasts for 2012 and 2013 to 7.7 percent and 8.0 percent, respectively. We are confident that there will be no need for policy rate hikes in H2-2011, as policy makers will opt for SRR tightening before adjusting interest rates in order to sustain the current growth momentum.
Balance of payments to stay in surplus
`March trade data suggested that growth momentum is picking up. Exports rose by a record 59.5 percent y/y to surpass USD 1 billion, and strong remittance inflows support the reserves. Imports, which surged 73 percent y/y, continue to outpace exports, reflecting robust economic activity. High oil prices could also put pressure on the balance of payments going forward. That said, export earnings posted strong growth of 54.3 percent y/y in Q1, rising to USD 2.7 billion, and the balance of payments showed a surplus.
The garment sector registered the strongest growth, with apparel export earnings increasing by 74.2 percent to USD 1.2 billion (compared to just USD 0.7 billion in Q1-2010). This can largely be attributed to global suppliers shifting production to Sri Lanka due to tensions in the Middle East and North Africa. Tourism earnings are projected to exceed USD 1 billion by year-end, based on current trends (tourism receipts increased by 55 percent y/y for the January-April period) this, along with inflows to the capital and financial account, should ensure that the balance of payments remains in surplus in H2. The next USD 1bn sovereign bond issuance, expected in August, should also boost inflows and will be used largely for short-term debt repayments.
IMF expresses confidence in policy framework
`The IMF.s disbursement of the seventh tranche of its USD 2.6 billion loan to Sri Lanka reflects confidence in the authorities overall policy framework. However, the underlying messages from the IMF on the investment front are worrisome. While the government has taken comprehensive steps to provide investors with greater clarity on investment guidelines and regulations, more work needs to be done if the authorities are to achieve their USD 1 billion FDI target for 2011. Notably, FDI inflows in Q1-2011 were heavily concentrated in two sectors, tourism and telecommunications. The IMF has cautioned that clear evidence of increased transparency and improved governance is needed to attract investment to other sectors.
`The lack of private-sector participation in economic development is an ongoing concern. In its 10 June post-mission review statement, the IMF highlighted `a perception that the government is sending some potentially conflicting signals about the role of the private sector in economic development.`Such perceptions could deter investment.
`Allegations from opposition parties have surfaced that the government has tried to transfer resources from the private sector to the public sector in order to buy private-sector assets. An example of this is the recent controversial pension reform bill. While it was not passed in parliament, it raised concerns that the government was building a third state-controlled fund to which private-sector workers would be compelled to contribute an additional 2 percent of their wages.
`The government s objective appears to be to create the pension fund as a social safety net for an aging population.
However, it is unclear how this third fund would achieve its end goal, given that Sri Lanka already has two state-controlled superannuation funds the main one is the Employees Provident Fund (EPF), to which private-sector workers contribute 23 percent of their wages. Further, concerns are mounting that the state s use of EPF funds to trade in shares of commercial banks could be misconstrued and lead to negative investor perceptions.
Fiscal consolidation continues
`Revenue collection in Q1-2011 increased by 19.5 percent to Rs. 218.4 billion on stronger growth in tax revenue, which rose 24 percent (to 2.9 percent of GDP). This was largely due to the implementation of the tax reforms announced in the 2011 budget. Total expenditure, however, increased by 13.6 percent in Q1, causing the fiscal deficit to widen by 4.84 percent y/y to Rs. 127.6 billion, or 2 percent of GDP. This would translate into an annualised deficit of 8 percent of GDP for 2011 if current trends continue, which would exceed the central bank s 6.8 percent target.
`Domestic sources contributed 85 percent to the financing of the fiscal deficit. In our view, state spending will need to be tightened if the government is to achieve its 6.8 percent deficit target.
Rupee appreciation to gather speed
`The favourable balance of payments, along with the central bank s greater tolerance of currency gains, saw the Sri Lankan rupee break decisively above 110 in early Q2-2011. While we are structurally bullish on the rupee, we had expected ongoing concerns in the euro area to weigh on the currency, leading to some retracement of these gains. On the contrary, the rupee has proven extremely resilient to global issues.
`As a consequence, we recently revised our trajectory for USD-LKR lower. We now forecast it at 108.4 at the end of 2011 (versus 109 prior). This reflects the positive outlook for continued foreign investment in Sri Lankan bonds, and the view that the central bank will be more willing to use the currency than interest rates to contain any renewed inflation risks.
T-bond yields to be range-bound
`With inflation showing signs of softening and policy rates expected to be stable, we expect the T-bond market to be well supported in the near term. However, the medium-term trajectory of T-bond yields will depend on how the government chooses to finance the deficit and the resulting supply dynamics. If the government were to achieve its budgeted fiscal deficit for 2011, the proceeds of announced sovereign debt issuance of USD 1 billion would likely be used to reduce borrowing from domestic markets. In such a case, we estimate net supply of c.LKR 6 billion for the remainder of 2011, which is likely to prevent a significant compression in the term premia of T-bonds. Overall, we expect T-bond yields to be range-bound, with the 4Y yield peaking at 9.00 percent,` the Standard Chartered Bank report said.
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