The Central Bank (CB) took a loose monetary policy stance in August, 2 months ahead of our expectations. In our view, the early move came on the back of both internal and external headwinds to growth potential. Overnight excess liquidity recorded a 15.8% MoM decline while credit growth decelerated to 7.7% YoY in July, with lending to both the private and public sectors trending down. Meanwhile, premium fuel and 92 Octane prices were increased, in-line with the ASEC fuel pricing formula. The LKR witnessed some pressure, recording a 1.1% MoM depreciation on the back of government bond outflows. With import demand continuing to grow at a slow pace, we expect less near-term pressure on the LKR. We revise our official reserve forecast downwards from LKR 9.0bn to LKR 8.0bn on a lower probability of a third sovereign bond issuance and the downward revision of reserves estimate by the CB. Meanwhile, the weak government revenue collections from Jan-June 2019 signals a worsening of the fiscal deficit for 2019. Looking ahead, we expect the Presidential nominations to help ease political uncertainty to some extent. However, we continue to expect policy uncertainty to remain heightened. We forecast 2Q ‘19 GDP growth at 1.5% YoY and 2019 growth of 2.5% YoY. We forecast growth of 3.8% YoY in 2020 and the LKR to appreciate by 2.1% for 2019 at LKR 179.00.
Key policy rates lowered earlier than forecasted to stimulate economy
Key policy rates were loosened, against our expectations for this month by 50bps. This results in the total rate cut for the year coming to 100bps, together with a total SRR reduction of 2.5pp. In our view, the earlier than anticipated rate cut came on the back of 1) looser monetary policy stance taken by the region and other developing economies, 2) a widening output gap, 3) global and domestic headwinds to growth potential, 4) lower than anticipated credit and monetary expansion, 5) a contracting trade deficit leading to a stable balance and 6) stable inflation.
Government bond outflows weighs on currency despite interventions
On the currency front, the USD/LKR recorded a 1.1% MoM depreciation in August, inline with our expectations (compared with an appreciation of 0.01% MoM in July). The YTD appreciation was ~2.5%, with the currency ending the month at an average of USD/LKR 178.00, after reaching LKR 180.00. In our view the depreciation was mainly on the back of high outflows from the Government bond market, which recorded an outflow of USD 77mn until the 3rd week of August. A key factor during the month was the CB’s intervention in terms of market correction during the month in order to minimise the impact of outflows. Looking ahead, given the decelerating private credit growth combined with low import demand, we do not expect significant pressure on the LKR.
Reserves estimate lowered on low probability of a third ISB
We revise our 2019 reserve forecast from USD 9.0bn to USD 8.0bn, in-line with the CB’s revised estimate (USD 9.5bn previously). This mainly comes on the back of a lower probability of a third sovereign bond issuance (our initial expectation was for a USD 2.0bn sovereign bond issuance towards September 2019). We factor in 1) USD 500mn inflows from the Samurai bond issuance, 2) USD 585mn from the Hambantota port lease agreement, and 3) slow import demand to our reserves forecast. Amidst this backdrop, we forecast reserves to reach USD 8.0bn by end 2019, covering 4.8 months of imports.