At the second Monetary Policy meeting under the newly appointed Governor, Dr. Nandalal Weerasinghe, the Central Bank (CB) maintained key policy rates unchanged, in-line with our view. SDFR currently stands at 13.50%, and SLFR at 14.50%. However, the arbitrage opportunity remains, where the 1-year Government bond yield was significantly higher than the SLR. However, the CBSL notes that yields look to ease off and stabilise in the near term once fiscal consolidation efforts are announced. Our key takeaways are: 1) further rate hikes of 250 – 350bps likely for the rest of 2022, 2) currency volatility to ease to some extent as open account transactions reduce, 3) inflation to spike up further in the near term but, to taper down towards year end, 4) improving political and social stability a key requirement for economic recovery. We expect 2022 GDP to contract by 2.0% - 3.0% YoY. Our key concerns at this point are 1) growth impact from concerningly low forex reserves, 2) low room for fiscal assistance to support growth, 3) the absence of a medium-term policy framework for the government’s revenue generating policies and 4) elevated global commodity prices and 5) a possible global recession.
CB maintains rates; expects G-Sec yields to moderate and stabilise
In-line with our view, the CB maintained key policy rates at yesterday’s meeting, following the 700bps hike in April. While inflation is expected to remain elevated in the near term, the lag effect of such policy measures combined with complimentary policy measures are likely to result in inflation tapering down to some extent in the coming months. The Governor also stated that interest rates have also adjusted following the April rate hike, credit expansion looks to have eased as a result. As such, the weekly average AWPLR has increased 13.70pp since January 2021 (currently at 19.36%) amidst an overnight liquidity shortage of LKR 589bn. 1-year bond yields picked up sharply since last month, now at 24.50% (unchanged since the previous auction). Notably, CB holdings of government securities remained high, at LKR 1.9tn. However, we note that the SLR (14.50%) is higher than 3-mth yields (24.07%), creating an arbitrage opportunity in the market. The CB expects yields to stabilize at lower levels following the Government’s fiscal consolidation plans and interim budget expected in the weeks ahead.
USD/LKR pressure eases with CB guidance on inter-bank rates; Our base case forecasts the USD/LKR at 370.00 by year end
While the currency recorded sharp volatility in the past months, this has eased to some extent with the CB’s steps taken to curb volatility. As such, the CB looks to 1) curb imports through open market accounts (excluding export oriented), 2) provide guidance to banks in inter-bank spot rate movements and 3) reduction in the proportion of mandatory foreign exchange sales by the banks to the CB to support Dollar liquidity. Furthermore, we note that the variance between official and parallel market rates have considerably narrowed, leading to potentially increased remittance inflows through official channels (we factor in USD 310mn remittance inflows per month for the rest of 2022).
While the decision to clamp down on open account imports is a positive, we note that a number of essential commodities (potatoes, onions, dhal) are imported through open accounts. While the CB has indicated that LCs for such imports will be undertaken through banks, we note that the current Dollar shortage remains a concern. With existing food shortages, we note that the clamp down on open account imports could further pressure essential food supply in the near term.
We expect heightened pressure on the USD/LKR in the near term despite the efforts taken by the CB. While this will reduce volatility, Dollar liquidity remains a concern. Our base case forecasts the USD/LKR at 370.00 by year end while our worst case scenario forecasts the USD/LKR at 420.00 – 450.00 in 2022.
Reserves at USD 1.8bn; usable reserves at USD 50mn
Official reserves declined to USD 1.8bn in April, with usable reserves at USD 50.0mn according to officials. While the CB notes that negotiations have already begun with bilateral and multilateral partners to obtain bridging financing, we expect this to materialise post an announcement of an IMF staff level agreement. On the restructuring side, while financial and legal advisors are yet to be formally announced due to delays in forming a cabinet, we note that this has been finalised from the CB end. Given the delay in payment of USD 78.0mn due this week, we note that Sri Lanka is now in a “formal default” status. While this has an impact on the legal aspect, we note that this has already been factored into ISB prices. Our key concern at this point is if multilateral funding comes to halt in the event the Government cannot meet its payments.