Economic growth to rebound in 2013: SCB

Global giant Standard Chartered Bank tips Sri Lanka’s economic growth to rebound in 2013, after contracting this year from 2011.

It is forecasting economy to grow by 7.5% in 2013 and by 7.7% in 2014 from 6.8% this year. However, forecasts for the next two years are lower in comparison to record 8.3% growth achieved last year.

This estimate as well as key achievements in the recent past and salient existing and emerging challenges for Sri Lanka is contained in the just released Standard Chartered Asia Focus September 2012 titled ‘The Resurgence’.

The forecast of 6.8% growth in 2012 by SCB is slightly higher when compared with Treasury Secretary Dr. P.B. Jayasundera’s estimate of 6.5%, as reported in the Daily FT yesterday.

Noting that Sri Lanka’s policy measures to gain traction, SCB’s global research document said growth will pick up in 2013.

“The economy is in fair shape, and policy measures appear to be gaining traction. Despite the external headwinds of slowing global demand and rising food prices, the economy is poised to achieve 6.8% growth in 2012, and we forecast that growth will pick up to 7.5% in 2013,” SCB said.

“We expect domestic activity to compensate for lower export growth in 2013. Following the Central Bank’s implementation of policy tightening measures in H1-2012 – currency depreciation, two policy rate hikes in February and April, and an 18% cap on banks’ credit growth – the economy is on a stronger footing. However, policy makers are likely to remain cautious as long as external risks prevail. We expect growth to slow to around 6.3% in H2-2012 from 7.1% in H1, and inflation to moderate,” SCB added.

Although the Central Bank of Sri Lanka (CBSL) is mindful of higher inflation risks arising from domestic supply-side constraints and external factors, it will likely keep policy rates on hold in the near term to avoid jeopardising growth.

Following are the research report’s other observations on Sri Lanka:

The external and domestic environments remain challenging

We have revised our full-year 2012 growth forecast to 6.8% from 7.1%, with risks to the downside, to reflect the following factors: (1) The euro area, which accounts for c.30 of Sri Lanka’s exports, remains vulnerable to event risk and is expected to stay weak.

(2) With reduced hydropower supply due to a drought, Sri Lanka has had to shift to higher-cost thermal power generation. (3) The drought has had a significant impact on agricultural output, destroying close to 50,000 hectares of rice, according to the Finance Ministry. This has resulted in increased subsidies, with Rs. c.10 b allocated to drought relief for farmers. (4) We do not expect the 18% credit ceiling on banks’ lending, which has considerably slowed domestic consumption, to be lifted in the near term, as the Central Bank’s tight monetary policy stance is likely to prevail until inflation moderates.

Inflation to moderate by year-end

We have revised up our average inflation forecast for 2012 to 7.7% from 7.2%, as our earlier forecast did not reflect the spike in June inflation to 9.3% (from 7.0% in May) resulting from drought-related supply-side constraints. Inflationary pressure seems to be dissipating, with the rate of food inflation declining due to improved supply from the north.

However, we expect headline inflation to hover around double digits approaching the year-end, limiting the Central Bank’s scope for monetary easing to stimulate growth (unlike its regional counterparts). However, we think a rate cut is likely in Q1-2013 as inflation moderates. We expect a cumulative 50bps of rate cuts next year, taking the repo rate to 7.25% by end-2013.

BoP position to improve

The balance of payments (BoP) is improving. The monthly trade deficit has been narrowing since December 2011 and is at its lowest level since February 2011 thanks to slower import growth. The Sri Lankan rupee (LKR) is stable at 132.0 versus the US dollar, and credit growth – at 31.6% y/y in June – is showing early signs of moderating. Credit flows to the manufacturing and agricultural sectors recorded significant declines in June. These are clear signs that the Central Bank’s policy measures are gaining traction. Export earnings contracted by 2.2% in H1-2012 to US$ 4.9 b (compared with 35.1% y/y growth in H1-2011), and continue to fall due to faltering economic activity in the euro area. Lower apparel export earnings (c.40% of total export earnings) have been the main driver of this contraction, falling 1.6% y/y in H1-2012. We are also concerned about the contraction in imports of investment goods, as it likely signals a moderation in domestic investment and production – two key growth drivers.

The authorities have allowed greater exchange rate flexibility, largely ceasing FX intervention. This has helped the foreign reserves to stabilise at US$ 7.1 b (4.2 months of import cover) and curtail the trade deficit. Robust remittance inflows and tourism receipts are likely to continue and should help to narrow the current account deficit to 4.0% of GDP in 2013 from 6.1% in 2012.

However, should the slowdown in global growth persist, this might pose further downside risk to exports. Steady capital inflows, Government bond issuance, and further IMF support in the form of an Extended Fund Facility (still under negotiation) should help to finance the current account deficit and push the BoP further into surplus ;in 2013 (from an expected USD 0.9bn surplus in 2012).

Medium-term steps towards fiscal consolidation

According to the Finance Ministry, policy adjustments implemented in H1-2012 (including an increase in import duties to curb demand for imported consumer goods and a reduction in fuel subsidies) and the re-prioritisation of development activities will allow the Government to achieve its fiscal deficit target of 6.2% of GDP in 2012. However, we expect the authorities to overshoot this target.

We forecast a deficit of close to 7.0% due to losses at State-Owned Enterprises (SOEs), electricity subsidies, and the impact of the drought. Fiscal consolidation may prove challenging in the near term given that growth is expected to slow in H2-2012 and tax collection on external trade has fallen short of targets. Higher interest payments and the increase in non-interest expenditure on wages and welfare spending this year have also contributed to fiscal slippage. In 2013, steps to reduce current expenditure, broaden the revenue base and improve the efficiency of SOEs will be needed to reduce public debt and keep the fiscal deficit within our forecast of 6.5% of GDP.

LKR likely to remain stable

Given the improvements in the BoP due to slowing import growth and steady debt inflows, we remain optimistic on the USD-LKR and expect to see sustained appreciation. After heightened volatility when the Central Bank removed the USD-LKR trading band in February 2012, the LKR has now stabilised, and depreciated c.16% versus the USD in H1-2012. It is clear that USD-LKR in the 130-132 range is within the Central Bank’s comfort level. Given that exports have contracted for the past four months, the weaker LKR should benefit exporters.

The sharper-than-expected slowdown in exports due to weak global growth has limited the positive impact of export earnings on the trade deficit and on the LKR. We are now less optimistic on the LKR over the medium term and have revised our USD-LKR forecast, expecting it to settle at around 130.0 in Q4-2012 (versus our previous forecast of 123.5). We expect USD-LKR to remain within the 130-132 range until end-2012, as export weakness is likely to prevail. We expect some appreciation pressure in 2013, taking USD-LKR to 126.5 by end-2013, due to a revival of risk appetite as global growth starts to pick up and amid prolonged USD weakness.

Monetary easing in 2013 to support T-bonds

Two key drivers of the T-bond market – the CBSL’s hawkish monetary policy stance (in response to elevated inflation) and the Government’s excess market borrowing – have pushed the entire yield curve higher this year. The 4Y T-bond yield is c.420bps higher year-to-date in 2012. However, the long end of the yield curve has stabilised over the past quarter, while the short end continues to harden on the back of tightening banking-system liquidity, flattening the yield curve. The 1Y/4Y spread has narrowed by c.50bps over the past quarter. Given the upward revision of our inflation forecasts for the remainder of 2012, we expect the Central Bank to maintain its anti-inflation stance via stable policy rates and tight banking system liquidity. We therefore revise up our forecasts for 1Y T-bill rates for Q3-2012 (by 75bps to 13.50%) and Q4-2012 (by 25bps to 13.25%).

In 2013, we expect slowing growth to prompt a shift in the Central Bank’s focus from containing inflation to supporting growth, paving the way for mild monetary easing in H1-2013.

Such easing would be supportive of T-bonds; in combination with expected fiscal consolidation (we forecast that the fiscal deficit will narrow to 6.5% of GDP in 2013 from 7.0% in 2012), this should trigger a reversal of the up-move in long-end yields. However, we believe the magnitude of the reversal will depend on the extent to which the Government front-loads issuance.