Ringing in the New Year with uncertain economic prospects
File pic shows key personalities that dominated business and the economy in 2015: (From left): Central Bank Governor Arjuna Mahendran, Securities & Exchange Commission Chairman Thilak Karunaratne, Colombo Stock Exchange Chairman Vajira Kulatilaka and Prime Minister Ranil Wickremesinghe
If 2015 could be classified as the year of political change, signs are that 2016 would be a year where economic volatility and uncertainty prevails. In 2015, politics trumped economics and by the time political stability was reached or at least moved to an even footing, the economy saw a depreciation of its currency in early September. While Sri Lanka may have reached some degree of political certainty, at least in the short-term, a number of steps are required to shift the economic gear into drive.
Recap of 2015: A Year that saw movement in most economic variables
The year started with a slide in Sri Lanka’s reserves mainly to accommodate the redemption of the sovereign dollar bond issued in 2009. Since that turning point, the country has seen high volatility in reserves where sharp declines were recorded in periods of debt outflows and an increase was noted when foreign borrowings were raised. The interim budget in late January provided a further boost to the economy in terms of increasing the disposable income of consumers.
The Central Bank of Sri Lanka (CB) maintained the low interest regime and even cut policy rates in April, largely to facilitate domestic borrowing at a lower cost. Meanwhile, a surge in imports driven by consumer goods applied pressure on the trade account with subdued levels of export growth. Remittances which has historically grown over 5 per cent every year, has only grown 1.7 per cent in dollar terms for the first 10 months in 2015 compared to 2014. These reasons together with the refinancing of debt which bunched up in 2015 have added significant pressure on the Balance of Payments (BoP). The key inflation indicator went into deflation territory albeit briefly (July- September) but has since edged up to 3 per cent levels by November 2015. Tourist arrivals and earnings in dollar terms continued to grow in 2015 with growth for the first 11 months against 2014 at 18.1 per cent each.
Key themes to watch for in an
‘Uncertain 2016 Landscape’:
- The Policy Challenge
2015 was the year we saw an adjustment in the currency and volatility in rates, in particular in the local Treasury bond market. It is highly likely that this volatility will be the opposite in 2016 with more volatility of the currency and a sharp rise in interest rates across the board. One may argue that the Sri Lanka Rupee (LKR) against the US$ has already depreciated by 8 per cent, but we cannot discount that the adjustment simply puts the currency in line with Asian and emerging market peers which saw depreciation against the dollar as well.
The impact on interest rates and the LKR will be determined by three factors. Firstly, the policy direction the CB would want to pursue in particular for interest rates is a key factor. The longer those interest rates are held at current levels, the more it will result in the growth of non-fuel imports and consumption, leading to further pressure on the BoP. The longer the delay to tighten monetary policy, the more the LKR will be under depreciatory pressure. If the monetary policy is adjusted to reflect a higher interest rate regime, then we could see some degree of stability in the LKR. The CB will also be mindful not to stoke a private sector credit bubble similar to what was seen in 2011/2012, which required tightening the monetary policy that led to two years of subdued credit growth in the economy.
A second factor is the growth outlook. Growth under a new base (2010) is improving compared to 2013 and 2014. However, it is much lower than that the growth recorded under the old base. For example in the third quarter of 2015, the economy grew 4.8 per cent under the new base as compared to an estimate of 6 per cent for the old base. Hence, the question arises if there needs to be more support towards growth by the CB or an increase in interest rates to ease the imbalances in the economy.
The other key factor is how global markets play out in 2016 especially in an environment in which the US has raised its policy rates for the first time in almost a decade. If many of the emerging markets see depreciation similar to 2015, then the LKR could require a similar adjustment to be competitive. While all eyes are focused on the US, new data from China that would emerge next year would also be critically analyzed and have pass-through impacts towards markets like Sri Lanka especially if there is more weakness of the Yuan.
- Exploring opportunities for growth in 2016
The key obstacle is finding an avenue for short-term economic growth. Is it realistic to expect a similar trend to what was seen in the third quarter of 2015 to carry into most of 2016? This is given that the third quarter showed a slowdown in certain economic activities like construction and non-tradable goods (like banking and transport) which had supported growth in the last five years.
Foreign Direct Investments and widely-talked about Public Private Partnerships will have to take a leading position in driving investment growth in the island without a continued heavy reliance on commercial debt. In turn, we could see a favourable shift to a balance between a consumption and investment economy, given that the high levels of consumption in 2015 is unsustainable moving forward due to our debt levels and a lack of a buffer with our low level of reserves.
- levels of inflation could be back in play next year
Global food prices are rising after being subdued in recent years and this is expected to have a significant impact on countries like Sri Lanka which have a high percentage of food in their inflation basket (CCPI 2006/07 has 41 per cent). Other supply side issues such as the impact from the much discussed “El-Nino” weather condition could add to the pressure on food prices locally. The more the LKR depreciates the more likely inflation will absorb the resultant impacts of this variability. This could give a good enough reason for the CB to raise policy rates. The saving grace however, is that the price of hard commodities like oil are continuing to slide lower. This if sustained and passed through to the consumer, it could ease major inflation concerns.
- Crucial reforms to avoid repeat of future ‘Boom and Bust’ cycle
The medium term economic policy laid out by the Prime Minister has been hailed quite positively by most commentators. The next stage and possibly the most crucial will be the planning and execution of some of these policies. This is quite important in particular to avoid a repeat of the ‘boom and bust’ cycles of the economy we have grown accustomed to. Current data shows there is aboutUS$4 billion in debt and loan repayments between April 2018 to April 2019 (this calculation includes maturing sovereign, quasi-sovereign and SLDB bonds in addition to IMF repayments as well). This indicates that bunching up of debt similar to that seen in 2015 could occur in 2018/2019 if steps are not taken next year to redirect the economy from this precarious position.
- SL credit rating under threat owing to lack of fiscal consolidation
Sri Lanka requires a sovereign rating by an international rating agency every time it wants to tap into the international capital market to raise dollar bonds. Most economic commentators including the IMF have been looking at the 2016 Budget to see feasible revenue initiatives and moves to reduce the budget deficit. However, the budget provides rather optimistic revenue growth targets with a lack of steps to reduce the deficit and address the growing debt levels.
In post-budget commentary, rating agencies such as Fitch Ratings have commended the reform initiatives, but has stated that there is a lack of fiscal consolidation in the medium term. Moody’s has issued a report which says fiscal targets for 2016 will be credit negative. The key risk for Sri Lanka on the horizon is either a negative ratings outlook or a ratings downgrade where growth, external funding and fiscal consolidation remain uncertain.
- Future external commercial borrowings could be difficult and at a higher rate
With the US increasing its policy rates in December 2015 and fueling expectations for more changes, most analysts expect that there could be a slowdown in money flowing to emerging markets which have enjoyed a considerable level of liquidity flowing into their markets. Sri Lanka has been a key beneficiary of these fund flows both for local instruments as well as for sovereign dollar bonds. However, future ones in 2016 could be at much higher rates. Already the latest data shows that the 6.85 per cent 10-year bond raised at the end of October is trading 1 per cent higher in the secondary market.
A faster than expected pace in tightening by the US Federal Reserve could be negative for emerging and frontier markets like Sri Lanka in particular if hot money flows out of these markets back to safe havens like the US. Sri Lanka in 2015 has seen a decline of about Rs.150 billion in foreign holdings of local government securities and would be sensitive to further declines, if emerging markets see further outflows.
Overall, 2016 will continue to be a challenging year for Sri Lanka’s economy with many moving pieces in play. The political economy both locally and externally, will need to be carefully managed if a stable footing for the economy is to be achieved in the short-term. There are three broad takeaways from for my expectations for 2016:
- It could be a year of volatility for the currency while we see an adjustment that sees higher interest rates.
- The growth and external funding outlook will be uncertain with the latter depending on global market movements.
- Finally, if reforms are pushed forward in 2016 the economy could move forward by incorporating lessons learnt from previous years.
(The writer is Lead Economist and Senior Product Head at Frontier Research. He can be reached on shiran@frontiergroup.info <mailto:shiran@frontiergroup.info> or on twitter @ShiranFdo <https://twitter.com/ShiranFdo> )