Overheating symptoms in Sri Lankan economy

UBS Securities Asia Limited, last week released a research analysis on recent achievements of Sri Lanka’s economy as well as future scenarios. The report also contains several warnings. Here are excerpts.

The exchange rate is under pressure to depreciate. Sri Lanka’s central bank left official interest rates unchanged at their last meeting. While this was expected by many watchers, it is highly questionable for how long further rate hikes can be delayed without prompting further currency weakness. The simple reason is Sri Lanka’s balance of payments is weak and in 2012 higher yield will be needed to restore exchange rate and inflation stability.

We envisage policy rates needing to go up 150-200bp. As a result, after recent years of 8%+ economic growth we are more downbeat on economic growth in 2012 and expect an economic slump to c. 6% as the authorities are forced to tighten up policy.

Basic picture

The economy appears to have over-expanded (8.4% as of Sep-11). Many still believe that Sri Lanka has managed to attain a new higher 8% trend growth. We disagree. At a basic level the savings rate is too low to support the kind of investment rate that has produced 8%-8.5% real GDP growth since 2010. Whereas in 2010 a savings rate of 24% supported investment of 26% of GDP and produced a minor current account gap of 2-3% of GDP, by end 2011 this imbalance had deteriorated considerably. The current account in 2011 widened to around 10% of GDP on our calculations (table 2). 2011 was also a year when credit growth was permitted to accelerate by 37%. It’s not so much a degree of leverage problem, but a speed of expansion problem. On top of this, the 2010 improvement in government finances has stalled. Some of this credit expansion is supporting a rather fat fiscal deficit of c.8% GDP - versus the plan to reduce it to 6.8% in 2011 and 5.2% in 2012. This will need to be re-set lower because as the economy cools off tax buoyancy will be tested. The structure of rates needs to rise to reflect the higher yield required to bridge the current account gap and the rebound in inflation in prospect.

Weak balance of payments

Sri Lanka is ill-equipped to run these kinds of imbalances. It has a very low cushion of official FX reserves of c. $6bn as of Dec-11, down from a peak of $8bn in Aug-11. In essence we think monetary policy was left too loose for external global conditions. The economy expanded and non-oil imports went up. At the same time the slowdown in global growth depressed exports and the country was caught with a rapidly widening trade gap1. Higher oil prices aggravated the condition. But this is not a simple case of oil pulling the trade balance out of shape, last two years saw non-oil trade gap widen from 1.8% of GDP to 9.2%. The country enjoys a steady influx of remittances (of around $380m per month). While in 2010 this was enough to counterbalance the monthly trade gap, by 2011 it was insufficient (the trade gap ballooned way beyond this to average $1bn per month in the last 6 months). Consequently, this has led to a wider current account funding gap and a draw-down in official foreign exchange reserves to cover it. Ultimately, official reserves are just a buffer (equivalent to 6m of imports). Periodic global bond issues can help plug this gap, but without a compensating rise in yields and a cooler economy this wider current account is going to continue to drain official reserves and push the exchange rate weaker.

Inflation illusion

Headline inflation has slowed to sub-5% (2.7% Feb-12) from a peak of 8.8% in Apr-11. There are a few reasons for the remarkably tame inflation rate during the 2010-11 overheating episode. First, food inflation has slowed dramatically; second, despite rising oil local fuel tariffs and transport costs were suppressed. Third, the exchange rate was stable, if not appreciating for a while. Finally, there can be a lag between excess demand and inflation.

2012 could turn out to be the opposite. The suppressed inflation within transport is finally percolating through, the exchange rate is depreciating and the effect of rapid credit growth is likely to accommodate higher pricing power.

The net effect of these factors could be to lift headline inflation back to the 5-10% range in the months ahead. Nonfood inflation could be a better short term gauge of inflation pressures - this remains higher at 7.4%. Perhaps the bigger question is how should we regard this upcoming inflation episode. Is it a repeat of that in 2006-8, 2000-2 or even the early or mid-90s? The inflation impulse varies in each of those periods. Food plays a large role in each one. Another common feature is exchange rate weakness. In almost every case a devaluation or slide in the exchange rate of at least 5-10% has accompanied the inflationary impulse. Today, food inflation is slow, but there is exchange rate weakness which to us suggests headline CPI can zip back up to 8-10% in 2012. A re-run of the 2006-08 inflation episode seems unlikely given the softness in global pricing of food and manufacturing.

Interest rates in catch-up mode

But when it comes to policy rates it is more than a simple question of inflation profile. In current global conditions there may be a more urgent need for a catch-up in policy rate hikes due to the weakening balance of payments and still rapid credit growth (37%). The 2011 current account (using monthly merchandise trade and remittances) as a proxy is close to -$6bn which, in turn is around 10% of GDP - roughly three times that in 2010.

As a small open economy with low foreign exchange reserves there is very little room for the central bank to conduct independent monetary policy in the face of an external shock. The central bank started in earnest to hike policy rates by 50bp in February, but we feel much more is needed. While we do not see the kind of ramping up in the structure of rates that happened in 2006-08 or in the early 2000s (inflation is not enough of a problem for that) we do forsee the whole market rate structure rising another 150bp, with the official reverse repo/repo rates hiked another 150bp. Our current expectation is peak official reverse repo/repo rates up to 10.5%/9%. Central bank meetings are monthly so we fully expect rates hikes in the next few.

Fiscal improvement stalls

Fiscal discipline has been an Achilles heel (as is the case in much of the rest of South Asia). While the fiscal deficit has improved it could be short-lived. We suspect expectations ran ahead of reality and looking ahead into 2012 a slower economy will mean that further improvement is unlikely without spending cut-backs. By way of a brief review, Sri Lanka’s budget deficit and general government debt ratios were high in 2010 at 8% and 82% of GDP.

The war ended in 2009 and after the parliamentary and presidential elections (early 2010) the 2011 budget implemented many of the recommendations of a Presidential Commission on Taxation. These included moves to: simplify the system, broaden the base, lower tax rates and improve collection. Corporate and personal tax rates were cut from 35% to 28% and 24% respectively - the burden of taxation swung more towards expenditure taxes. But long term tax exemptions were given to large state owned enterprises (SOEs) such as power, airlines and petroleum. And there were no major incentives on the spending side. In 2011, despite the 8-8.5% real GDP growth, what appears to have happened is a slide in tax collection while spending has gone up. As a result the gap has centered around 8% of GDP and not declined to the 6.8% as planned (chart 14). Certainly 5.2% in 2012 looks quite out of reach given the slowdown in economic growth in prospect. While it may be early to judge the full impact of these tax improvements it is easy to envisage how tax gains can be given back easily through spending leakages in a year where economic growth sinks. Consequently, we do not expect further fiscal improvement in 2012. Credit ratings which may have been granted on the basis of further fiscal improvement may be tested in 2012.

Economic activity

How does the business cycle look? This is not yet an economy predominantly driven by exports. Exports are equivalent to 17% of GDP. Yet big swings in exports can affect activity and real GDP (chart 2). On the domestic side the main components of GDP were just starting to hook over in Sep-11; this should continue (chart 17). The monthly indicators are in general softer with exports in an advanced state of slowdown. Taxes and real cash in circulation (a measure of wholesale & retail transactions) are both already slower (chart 19). All these are yet to be confirmed by a slowdown in real GDP headline numbers. IP and implied profits (calculated from CSE all share listed universe) have yet to decisively slow though we suspect they too will follow the move lower in export trends soon (chart 18). As with other economies we do not envisage a sharp arresting seizure of economic activity (as happened in 2009 post Lehman’s bankruptcy), but a more moderate one. However, the key to escape from this slump (as in other places) will not be policy stimulation. Sri Lanka cannot afford much in that department. Instead recovery will ride on: (i) global growth and export trends (which should look up from June quarter onwards and; (ii) the ability of the local private sector to stage a rapid profits recovery following interest rate hikes and a fuller translation of higher fuels costs - lagged. In sum, we see real GDP growth slow to c. 6% in 2012 while businesses adjust to the higher costs of doing business.

Conclusion

Sri Lanka is going through a modest episode of overheating. We expect interest rates in Sri Lanka to go up another 150-200bp to reflect the much wider external gap and higher headline inflation in prospect. The domestic economy is already softer, but further weakness appears likely as higher rates depress spending and the current red-hot credit growth slows down. Overall we look for real GDP growth to slow to around 6% in 2012 from a number likely to be close to 8% in 2011.

The fiscal picture started to improve, but this trend has stalled as higher spending has used up some of the tax gains. While this is not a fiscal or balance of payments crisis for investors financial markets could be in for a bumpy time while the economy adjusts to the higher inflation lower growth mix.