The Sri Lankan economy is likely to face multiple headwinds over the near-term arising from a volatile agricultural sector, a poor consumer outlook, as well as rising risks of a balance of payments crisis. However, the industrial sector is likely to recover over the coming quarters on the back of a more stable political climate. As such, we forecast Sri Lanka's economy to grow at 4.8% in 2016, marking a stabilisation of growth from 2015.
The Sri Lankan government will have to agree to austerity measures imposed by the IMF in order to secure a USD1.5bn bailout as the country faces risks of a balance of payments crisis. Under the conditions of the bailout, the government will likely have to reduce its budget deficit to 5.4% of GDP by end-2016. In addition, the CBSL will be forced to raise interest rates and devalue the currency in order to build a foreign reserves buffer. However, we believe that the government will face difficulty in making short-term adjustments to its budget due to political gridlock and high interest costs.
The election of President Maithripala Sirisena in January 2015 and the UNP's victory in the August general election have been positive for socio-political and economic reforms in Sri Lanka. However, we note that the loose coalition arrangement (which is made up of two parties from opposite ends of the political spectrum) is highly susceptible to political gridlock, and will be a risk to the policy-making process in the country. At the same time, there is also a possibility that the Joint Opposition could gain traction due to defections from the Unity Government. Accordingly, we have dialled back the Short-Tem Political Risk Index Score to 71.5, from 72.3 previously.
Major Forecast Changes
The rupee will likely face further downside pressure over the coming months due to persistent capital outflows and the requirement to build up a foreign reserves buffer under the IMF's guidance. This informs our expectation for the unit to weaken to LKR155.00/USD by end-2016, versus our previous forecast of LKR152.00/USD. Nevertheless, the currency will likely stabilise and average LKR156.10/USD in 2017 as investor confidence gradually recovers.
The CBSL will likely adopt a more aggressive monetary tightening stance in order to slow credit and money supply growth. In addition, higher interest rates are also necessary for the CBSL to build up a foreign reserves buffer (in line with IMF demands). As such, we expect the central bank to hike its benchmark deposit and lending facility rates by 50bps to 7.00% and 8.50%, respective, in H216.
If the government fails to secure the IMF bailout, there could be a rapid deterioration in investor confidence, leading to an acceleration in capital outflows. In this case, the Sri Lankan rupee could overshoot the LKR155.00/USD mark.
While we do not expect the CBSL to introduce strict capital controls, it seems likely that the monetary authority will impose more regulations to govern the flow of foreign currency.
|Real GDP growth, % y-o-y||4.9||4.8||4.8||5.4|
|Nominal GDP, USDbn||79.1||82.4||80.8||84.0|
|Consumer price inflation, % y-o-y, eop||2.1||2.8||3.0||3.0|
|Exchange rate LKR/USD, eop||131.21||144.25||155.00||157.32|
|Budget balance, % of GDP||-5.7||-7.1||-6.5||-6.4|
|Current account balance, % of GDP||-2.5||-2.4||-2.0||-2.0|
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