SCB checkmates cameo CB!

The Standard Chartered Bank (SCB) has opined the Central Bank’s forecast of $ 25 billion foreign inflow as “optimistic” given external headwinds whilst cautioning that pressure was mounting on the rupee given the rising import demand.

This view along with weaker GDP forecast is contained in SCB's latest country update titled 'A challenging year ahead' following the presentation of the roadmap for 2012 and beyond by the Central Bank.

SCB acknowledged the robust outlook for the economy by the Central Bank forecasting 2012 growth at 8.0% and achievement of 8.3% growth in 2011.

“However, the roadmap disappointed in not addressing the external-sector challenges posed by the deepening current account deficit and falling FX reserves,” opined SCB.

It argued that the global challenges of a faltering US recovery and the ongoing euro-area debt crisis continue to undermine confidence in global financial markets and remain the biggest impediments to Sri Lanka’s growth in 2012.

“While the key growth drivers of tourism, remittances (now Sri Lanka’s biggest foreign exchange earner, estimated at USD 5.2bn in 2011), and construction continue to underpin the economy, we believe sustaining growth at 8.0% levels will be challenging,” SCB said.  On account of this and other concerns, SCB is maintaining its 2012 growth forecast of 7.5%.

To back its weaker growth outlook SCB listed key concerns.

 (1) The US and Europe are Sri Lankas biggest export markets and together account for c.56% of exports. Reduced demand from both markets in 2012 is likely.

(2) Given the debt crisis in Europe, growth in tourist arrivals (close to 35% y/y as of end-November 2011) is likely to slow unless increased arrivals from Asia compensate. Western Europe currently accounts for 37% of tourist arrivals to Sri Lanka, followed by India (20%) and East Asia (11%).

3) The ongoing political turmoil in the Middle East may have longer-term implications for remittance inflows via lower migration of Sri Lankan workers to the region. It could also affect Sri Lanka’s main agricultural export, tea, due to faltering demand in 2012. Tea exports to the Middle East and North Africa comprise 55% of Sri Lanka’s total tea exports.

(4) If the EU decides to ban crude oil imports from Iran, this could put upward pressure on global crude oil prices and have severe repercussions for Sri Lanka’s balance of payments (BoP), as petroleum makes up c.25% of the country’s import bill. We are leaving our crude oil forecasts for 2012 unchanged for now – ICE Brent at 95 USD/barrel (bbl), NYMEX WTI at 85 USD/bbl, and Dubai at 93 USD/bbl in Q1 – as we believe Iran’s exports will continue to reach the global oil market. As a result, we maintain our Q1-2012 forecast for Sri Lanka’s GDP growth at 7.5%.

SCB also said that CB’s estimate of foreign capital inflows appears optimistic

Sri Lanka’s BoP is likely to come under significant pressure this year. The year-to-date trade deficit widened to USD 7.73bn as of end-October 2011, surpassing the record full-year deficit of USD 6bn in 2008. With investment and intermediate goods dominating the country’s import basket due to the strong post-conflict infrastructure push, the central bank is under mounting pressure to further depreciate the Sri Lankan rupee (LKR) to curtail rising import demand. However, it maintains that “a large volume of foreign currency inflows” are expected soon. We have factored in one more currency devaluation, taking the LKR to 115.8 against the USD in Q2-2012, in response to the bleaker trade outlook. Since most of Sri Lanka’s imports are necessary items, further LKR depreciation could potentially deter growth; hence, the central bank is likely to hold off on such measures unless capital inflows fall short of expectations.

The central bank has been criticised for its current strategy of defending the LKR at the expense of its FX reserves in the face of rising import demand. FX reserves are estimated to have fallen sharply to USD 6bn (four months of imports) as of end-2011 from USD 8.2bn as of end-August.

“In its policy roadmap, the CBSL estimated USD 25bn of foreign inflows in 2012. This appears optimistic given the gloomy external environment, in our view,” SCB said.

Projected foreign capital inflows are comprised of USD 12.5bn of export revenues (up from an estimated USD 10.5bn in 2011), USD 2bn of FDI (doubling from 2011), USD 6.5bn of remittances (a 25% y/y increase), and USD 1.2bn of tourism inflows.

The CBSL’s export growth projection of 19% for 2012 appears ambitious given that the US and Europe are Sri Lanka’s key export markets, and that competitor countries have also depreciated their currencies. Our export revenue growth forecast is more conservative, at c.10%; we expect FDI to fall short of the CBSL‟s forecast by USD 0.5bn amid the prevailing global uncertainty. The passage of the expropriation bill in November 2011, which nationalised certain assets of underperforming private enterprises, may also deter investors, as it undermines policy consistency.

Remittance inflows should continue to grow at trend levels, despite current tensions in the Middle East; the central bank estimates a 27% y/y increase by end-2011. A greater focus on migration of skilled workers, government negotiations to increase the average wages of overseas workers, and a diversification of overseas employment markets seem to be paying dividends. Given the estimated USD 850mn of tourism earnings generated in 2011, we believe the CBSL’s USD 1.2bn projection for 2012 is realistic, particularly since Sri Lanka will host the International Cricket Council (ICC) Twenty-20 cricket tournament this year. However, to achieve this target, tourist arrivals from Asia must also offset the potential decline in arrivals from Western Europe.

The central bank announced in its roadmap that it was keen to negotiate a follow-up surveillance programme with the IMF after its existing USD 2.6bn loan programme ends in May 2012. In our view, such a programme would be positive for investor sentiment and would appease the private sector. However, the central bank’s stance of continuing FX intervention may not be viewed favourably with the IMF. Furthermore, the central bank’s view that BoP pressure is temporary contradicts the Treasury Secretary’s view that external imbalances must be addressed, and highlights policy differences that have emerged since the 3% LKR devaluation in November 2011. This concerns us, as an uncertain policy environment could negatively affect investor sentiment.