Thursday, 4 July 2013 02:01
Cites shortfall in tax revenue as a key risk but expects pick-up in domestic activity as a cushion
Maintainsneutral stance on T-bond duration; says recentUSD-LKR gains are temporary
The Standard Chartered Bank (SCB) Global Research has described Sri Lanka is stable on the policy front and there was no pressing need to adjust the policy levers at present.
However SCB in its latest Asia Focus research cautioned shortfall in tax revenue as a key risk to macro stability though the Bank expects a pickup in domestic activity to boost higher tax revenue. SCB also noted 2013 fiscal deficit target appears difficult to be achieved.
Commenting on markets, the SCB maintains a neutral stance on T-bond duration, as it expects yields to remain range-bound for the remainder of 2013. It also thinks that recent USD-LKR gains are temporary, and expects the broad downtrend in place since mid-2012 to resume.
See Page 2 for excerpts from the SCB report.
Stable on the policy frontSri Lankaâ€™s macroeconomic environment remains stable and we see no pressing need to adjust the policy levers at present. With domestic macro conditions expected to become more supportive as 2013 progresses, the mood is one of cautious optimism. Inflation continues to moderate, while growth remains stable. We maintain our 2013 GDP growth forecast of 6.5%, but with risks to the downside due to the slower-than-expected export recovery in H1-2013. The Central Bank of Sri Lankaâ€™s (CBSLâ€™s) recent monetary easing cycle has brought a cumulative 75bps of policy rate cuts since December 2012. The CBSL is confident that the two rate cuts are finally feeding through to the real economy, reflected in the decline in commercial banksâ€™ deposit rates since May.
Although domestic and global supply conditions are expected to improve, inflation remains elevated and is still a risk, owing to domestic factors. The expected moderation in headline inflation to 6.5% in Q2-2013 and Q3 is largely due to base effects and improvements in domestic supply; however, the electricity and fuel price hikes implemented in April and adverse weather conditions could put upward pressure on inflation in the coming months. We expect inflation to spike in Q4-2013 due to a pick-up in domestic demand and private-sector investment resulting from policy easing and lower interest rates. We believe the Central Bank will maintain its status quo on policy rates and keep the repo rate at 7.00% until at least Q1-2014.
Recent trade data has been encouraging; the trade deficit narrowed by 23% y/y in Q1-2013; cumulative expenditure on imports fell 16%, while export earnings fell 8.1% y/y. We expect the external demand outlook to improve in H2-2013 due to brighter growth prospects in Sri Lankaâ€™s key export markets the EU and the US (which together contribute 50% of total export earnings). The government expects lower import expenditure across all categories, consumer, investment and intermediate goods including crude oil, and continued strength in remittances and tourism earnings in H2-2013 to narrow the current account deficit further in 2013 to 4.5% of GDP. Oil-price stability should also help reduce the losses of state-owned enterprises (SOEs).
We see the shortfall in tax revenue as a key risk to macro stability. The pick-up in domestic activity expected for the remainder of this year is likely to generate higher tax revenue; however, our GDP growth forecast of 6.5% (compared with the central bankâ€™s 7.5% target) suggests that tax revenue (budgeted at 19.2% of GDP to achieve the fiscal deficit target of 5.8% of GDP) may fall short. Fiscal consolidation should help moderate inflation; however, deficit reduction is contingent on restraining expenditure growth to offset weak tax revenue.
Market outlook: T-bonds to remain range-bound
We maintain a neutral stance on T-bond duration, as we expect yields to remain range-bound for the remainder of 2013. The key positives for T-bonds are a stable policy rate environment and strong demand from local market participants. The Central Bankâ€™s move on 26 June to lower the statutory reserve ratio by 2ppt partly offset the impact on T-bond yields of the sell-off in emerging-market bonds. The recent easing of monetary policy should support T-bonds. Private-sector credit growth slowed to 10.2% in April, indicating that demand for T-bonds is likely to be strong. The key negatives for T-bonds are upside risks to CPI inflation and expectations of fiscal slippage. YTD, the government has borrowed (via T-bills and T-bonds) Rs. 419 billion, the budgeted full-year amount. Such front-loaded borrowing has increased expectations of fiscal slippage and is likely to limit further T-bond gains. We expect the 4Y T-bond yield to trade between 10.75% and 11.25%.
USD-LKR gains are likely temporary
We think that recent USD-LKR gains are temporary, and expect the broad downtrend in place since mid-2012 to resume. This is primarily because the USD-LKR up-move has been led by higher import demand rather than substantial bond outflows, as has been the case in most emerging markets. In our view, Sri Lankaâ€™s muted economic recovery precludes the possibility of a substantial acceleration in import growth, as witnessed in early 2012. As such, we expect lower imports and continued strength in remittances and tourism earnings to narrow the current account deficit to 4.5% of GDP in 2013 from 6.6% in 2012. This should keep the USD-LKR under pressure, though periodic up-moves due to the global risks related to export growth and portfolio flows are likely. We recommend that exporters use these opportunities to raise their FX hedge ratios.