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Sri Lanka: Macro & Equity Update - Rate Cap Removed; Equities To Remain Favoured

  • Yield cap removal key corrective policy move; we forecast 1-yr yields at approx. 7.50% by year end

  • Yields have gradually increased but, issuances have gone under-subscribed

  • Low real interest rates to continue to favour equities in the near to medium-term

Asia Securities
21 September 2021
Published byAsia Securities

Yield cap removal key corrective policy move; we forecast 1-yr yields at approx. 7.50% by year end

  • The Central Bank removed the yield cap imposed on the 12-month bonds, which were in place for the past year

  • This comes amidst the overnight liquidity shortage reaching LKR 210bn (as of 16th September)…

  • …while forex reserves stood at USD 3.6bn, covering approx. 2.4 months of imports

  • In our view, the removal of the cap is a key signal to the end of elevated money printing which has added pressure to the currency, reserves and rates over the past year

  • While elevated money printing was the need of the hour amidst the COVID-19 impact in 2020 against low fiscal policy space, we note that the correction in policy is a key positive

Yields have gradually increased but, issuances have gone under-subscribed

  • During the last auction, the maximum yield rate for acceptance was increased to 6.12%, from 5.93% in August

  • While the rate cap was gradually increased during the last auctions, yields remained significantly low compared with the current economic backdrop

  • Despite the increase, government bond holdings have gone under-subscribed, with the last auction being meeting just over 50% of the issuance

  • While the removal of the cap is a positive, we do not factor in significant foreign inflows into the bond market owing to the external liquidity constraints combined with weak credit rating currently in place

Low real interest rates to continue to favour equities in the near to medium-term

  • Despite the removal, we expect real interest rates to remain muted in the near-medium term owing to elevated inflation

  • As of end August, CCPI was at 6.0% YoY; at the upper limit of the Central Bank threshold

  • While this is mainly stemming from supply-side factors, we note that non-food inflation has also gradually increased amidst high money supply

  • While we forecast inflation at 6.0% - 7.0% YoY in 2021, we note that this could be higher owing to low harvests in the Maha season owing to low chemical fertilizer availability

  • Our discussions indicate that crops have reduced 20% - 40% as a result

  • Against this backdrop, following the key policy rate hike in August, the weekly average AWPLR reached 6.28% in September so far (compared with 5.72% in August)

  • With a possibility of inflation moving higher in 1H 2022, it is our view that equities will continue to generate stronger returns in real terms and asset allocation will remain weighted towards equities at least until 1H 2022.