While progress will be made towards the resolution of ethnic divisions in Sri Lanka, the path to reconciliation will be an arduous one. Moreover, it is unlikely that demilitarisation in the northern and eastern part of the island will happen anytime soon, given the possibility of a resurgence of the Tamil Tigers
Sri Lanka's real GDP growth will slow in the coming quarters as low agricultural commodity prices and a relatively strong rupee continue to weigh on exports. Moreover, policy and political uncertainty will also keep growth subdued as investors adopt a wait-and-see approach. As such, we have downgraded Sri Lanka's 2015 real GDP growth forecast to 6.5% from 7.5% previously.
The Central Bank of Sri Lanka's (CBSL) monetary easing cycle has further to run as a combination of low inflationary pressures and below-target real GDP growth provides incentive for the central bank to act. Despite the strain facing the Sri Lankan rupee and its balance of payments, we forecast another 75 basis points (bps) of interest rate cuts, which will bring the Standing Deposit Facility and Standing Lending Rates to 5.25% and 6.75%, respectively, by end-2015.
Sri Lanka's trade deficit widened in December 2014 as the strong currency boosted imports and weighed on exports. Export growth in December 2014 came in at a modest 2.2% year-on-year (y-o-y), reversing the negative growth rate in the previous two months. Export growth is likely to remain subdued for 2015 due to the relative strength of the Sri Lankan rupee, while low oil prices will weigh on import growth .
We expect Sri Lanka's government debt as a share of GDP to fall to 73.6% in 2015 from 74.4% in 2014. While the pace of the decline has slowed since 2013 due to the government's irresolute budget consolidation, sluggish GDP growth, and broad exposure to foreign debt, the trajectory remains positive. Likewise, falling domestic Treasury bond yields will help to alleviate some pressure on the government debt situation going forward.
Major Forecast Changes
We have downgraded Sri Lanka's 2015 real GDP growth forecast to 6.5% (from 7.5%) on the back of weak agricultural commodity prices, sluggish export growth outlook, and political uncertainty.
We expect the Central Bank of Sri Lanka to cut interest rates by additional 75 basis points, which will bring the Standing Deposit Facility and Standing Lending Rates to 5.25% and 6.75%, respectively, by end-2015.
Key Risks To Outlook
Risk To Further Interest Rate Cuts : A rate hike from the Federal Reserve might lead to portfolio outflows among emerging countries globally; the CBSL might be forced to maintain high interest rates to defend the strength of the currency.
Risk To Trade Deficit: Sluggish export growth outlook and volatility in global oil prices could worsen the trade deficit more than expected. We have revised our average 2015 Brent Crude Prices forecast from USD53/bbl to USD59/bbl since May.
|Nominal GDP, USDbn||67.4||74.1||79.4||86.4|
|Real GDP growth, % y-o-y||7.3||7.7||7.5||6.5|
|Consumer price inflation, % y-o-y, eop||4.7||2.1||3.5||5.5|
|Exchange rate LKR/USD, eop||130.79||131.20||135.00||138.00|
|Budget balance, % of GDP||-5.9||-5.5||-5.3||-5.0|
|Current account balance, % of GDP||-3.9||-3.4||-3.1||-3.1|