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Sri Lanka: Macro Roundup - June 2022

  • IMF Staff level agreement likely by July; Govt expenditure plans crucial

  • 1Q signals currency depreciation, inflationary impact on economy

  • Demand for Government debt eases as local debt restructuring worries emerge; yields shift up towards month-end

Asia Securities
1 July 2022
Published byAsia Securities

The economic crisis deepened during the month, with continued shortages impacting activities. While the IMF Staff level visit concluded without an agreement, we expect this to materialise in July; a key step towards securing fiscal funding to ease the current pressure. Meanwhile, the impact of the prolonged fuel shortage was visible on the supply chain and factories, with productivity and supply chains negatively impacted due to power interruptions. The impact of continued disruptions was evident in a steeper than expected contraction in 1Q 2022 GDP growth. At this point, we revise our 2022 GDP expectations to a contraction of 7.5% - 9.0% YoY (5.5% YoY contraction earlier). We expect a sharp contraction in 2Q and 3Q 2022. Meanwhile inflationary pressure continued, with headline inflation reaching 54.6% YoY in June. We note that funding from an IMF EFF program is likely to take place towards December 2022/January 2023. We emphasise that the economic reform plan and a stronger political backdrop is key to mitigating the economic impact.

IMF Staff level agreement likely by July; Govt expenditure plans crucial

The IMF team completed their Staff level visit yesterday, with no firm finalisation of an EFF agreement. However, the team noted that considerable progress was made during their visit. This follows the virtual meeting which took place from May 9th – 24th. In line with our view expressed during the past few months, we expect the discussions to continue into July, with a likely Staff level agreement being finalised. According to the IMF team, given the unsustainable debt position, the need for a comprehensive economic program focused on corrective policy measures towards macroeconomic imbalances, public debt sustainability, and Sri Lanka’s growth potential are a key requirement to reach a staff level agreement.

1Q signals currency depreciation, inflationary impact on economy

The Sri Lankan economy contracted 1.6% YoY in 1Q 2022, following the 2.0% YoY growth recorded in 4Q 2021. This came in steeper than our forecast of a 1.0% YoY contraction owing to the slower than anticipated growth in the Services sector, combined with a steep contraction in the Agri sector during the quarter. The Services sector which accounts for over 50.0% of GDP grew by a moderate 0.7% YoY (+4.3% YoY in 4Q 2021), while the Industrial Sector contracted 4.7% YoY (+1.4% YoY in 4Q 2021). Meanwhile, the Agri sector recorded a sharp decline owing to the fertiliser shortage, contracting 6.8% YoY (-3.1% YoY in 4Q 2021).

Demand for Government debt eases as local debt restructuring worries emerge; yields shift up towards month-end

The surge in demand for government securities seen over the past few months tapered down in June. This comes despite one of the largest bond auctions of LKR 150bn taking place during the month. Concerns of a possible local debt restructure emerged, as debt restructuring discussions with the financial advisor, Lazard commenced. While we note that a local debt restructure remains a “last resort” for the Central Bank, with the IMF indicating that the total debt remains “unsustainable” indicates that proactive measures would need to be taken to bring the overall debt levels down. In our view, the Government’s first plan is likely to be SoE reforms, thereby easing pressure on the government balance sheet. We note that that the Central Bank maintains its stance that a local debt restructure will not take place.