Sri Lanka: Inflation trajectory to improve further

Tuesday, 27 January 2015 00:27 - - {{hitsCtrl.values.hits}}

New administration cuts fuel prices substantially, fulfilling a key electoral promise
Inflation trajectory looks even more benign now; this could raise expectations of a policy rate cut
We maintain our view of no rate change due to external stability concerns; but we acknowledge the risk of a new CBSL policy direction under new administration
Impact on T-bonds is likely to be limited amid stable policy rates; stay Negative on T-bonds

Standard Chartered Bank last week released its first post-presidential election Economic Alert on Sri Lanka. Here are excerpts: Summary Sri Lanka’s new administration announced substantial fuel-price cuts on 21 January, effective 22 January. The cuts will result in average reductions of 20% in petrol prices and 16% in diesel prices, according to our calculations. The new administration appears to have brought forward the price cuts from the initially planned date of 4 February (Independence Day) that local media had reported, citing official sources. An automatic price adjustment formula is due to be announced in the coming weeks. Lowering fuel prices was a key electoral promise of new President Maithripala Sirisena, who has committed to reducing the cost of living. The reductions followed prior cuts in September and December 2014 under former President Rajapaksa. Fuel prices have been lowered by a cumulative 26% since the cuts began. The latest fuel-price cuts are likely to lower the inflation trajectory further. We forecast non-food CPI inflation at -1.7% m/m in February, which would take the y/y figure further into deflationary territory (it stood at -2.0% y/y in December 2014) – see Figure 1. We expect headline CPI to decline by 1% m/m in February, translating into a y/y reading of +1%. Headline CPI inflation is likely to average close to this level until October 2015, after which base effects will turn unfavourable. In the absence of further fuel-price cuts, CPI inflation is likely to end the year in the 3.5-4.0% y/y range, comfortably within the Central Bank of Sri Lanka’s (CBSL’s) target range of 2.0-4.0% for 2015. We lower our average annual CPI inflation forecasts to 1.8% for 2015 and 4.5% for 2016 (see ‘Material changes’ table for details).

The improved inflation trajectory could raise expectations of a policy rate cut at the next CBSL meeting on 27 February. Our core view, however, remains that the CBSL will keep policy rates on hold due to concerns about external stability. A shift lower in yields in mid-2014 (Figure 2) resulted in heavy FII outflows from the local GSec market, which have totalled a net $ 430 m since mid-July. This is equivalent to 12.4% of total foreign holdings of domestic government bonds. Since the presidential elections on 8 January, outflows have totalled $ 30 m. FII ownership now stands at 11.3% of the total outstanding bond market, below the 12.5% limit set by the government (Figure 3). The Sri Lankan rupee (LKR) has come under pressure since September 2014, depreciating by 1.3% despite moral suasion by the CBSL aimed at keeping the exchange rate stable. Currency depreciation is particularly negative in Sri Lanka’s context given its high level of external debt. 44% of government debt is held by foreigners. Given this and improving growth indicators – import and private credit growth are on the rebound (Figures 5-6) – we see no imminent pressure to lower policy rates. Despite our core view of no policy rate change, we recognise that the new administration and CBSL governor may have a different view on central bank policy. Given the president’s electoral manifesto, we cannot rule out further monetary easing, as the new administration may want to send out a series of positive announcements to revive domestic sentiment. In the eventuality that the CBSL decides to ease monetary policy, we expect it to remove the 5% penalty interest rate charged on excess usage of the Standing Deposit Facility, and complement this with a 25-50bps policy rate cut. This would reduce the impact of banks parking excess liquidity in the GSec market, which would support yields. It would also be equivalent in a sense to marking monetary policy to market, as the call rate has traded below the Standing Deposit Facility rate (or repo rate) for some months now (Figure 4). Impact on rates market The fuel-price cut and its favourable impact on inflation dynamics are marginally positive for T-Bonds. However, in the absence of further policy rate cuts, the impact is likely to be limited. We therefore maintain our Negative T-bond outlook (see Rates Alert, 13 January 2015, ‘Asian rates 2015 – Cherry-picking Asian markets’). We are at the trough of the policy rate cycle, and T-bond valuations are unattractive. The current spread between the 5Y T-bond yield and the overnight call money rate is 140bps – lower than its two-year average of 200bps. Given unfavourable supply dynamics and the turnaround in the credit cycle, we expect T-bond yields to move higher and the yield curve to bear steepen.