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Wednesday, 26 March 2014 00:06 - - {{hitsCtrl.values.hits}}
Summary
The Central Bank of Sri Lanka (CBSL) has kept rates on hold in March, as we had expected – the Standing Deposit Facility Rate (SDFR) remains at 6.5% and the Standing Lending Facility Rate (SLFR) at 8.0%. The latest GDP and inflation data suggests that the CBSL is facing an improving growth-inflation trade-off. 2013 GDP growth, released on 17 March, surprised on the upside at 7.3% (versus our forecast of 6.8%). We have therefore raised our 2014-16 growth forecasts (Figure 1). Simultaneously, headline inflation continued to fall to 4.2% in February from 4.4% in January – it now stands at the lower end of the CBSL’s target range of 4.0-6.0%.
The increase in GDP growth in Q4-2013 is in contrast to signals sent by private credit growth, which remains extremely weak. Other indicators of domestic demand such as import growth and new car registrations have also failed to show a meaningful increase. We expect some of the divergence between GDP growth and proxy growth indicators to be erased by a gradual improvement in the indicators. We also expect quarterly GDP growth rates to moderate from Q4 levels going forward.
Policy makers have ruled out a change in rates in the coming months. Our previous call was that if private credit growth fails to pick up to close to double digits and headline inflation continues to fall by end Q1-2014, this could result in a further rate cut by the CBSL. We now defer these conditions until end-Q2, i.e., we think the CBSL will consider a policy change in mid-Q3 if data on private credit growth fails to show a pick-up by end-Q2 and inflation remains low. The caveat here is that the CBSL could keep rates on hold even if these two conditions are met, if GDP growth continues to show strong growth, as in Q4-2013.
CBSL on hold as the growth-inflation trade-off improves
As we had expected, the CBSL has kept rates on hold in March – the SDFR remains at 6.5% and the SLFR at 8.0%.
The latest GDP and inflation data suggests that the CBSL is facing an improving growth-inflation trade-off. The 2013 GDP growth rate, which was released at the beginning of this week, surprised on the upside. Relative to our forecast of 6.8% growth in 2013, official statistics reveal that the economy grew by 7.3%, with growth increasing sharply in the last quarter of the year (8.2% y/y in Q4, up from 7.8% y/y in Q3).
Though our forecasts for Q4 were close to the realised numbers for the agricultural and services sectors, the main upside surprise came from growth in industry – we expected 2.7% y/y in Q4, versus 10.7% y/y realised (Figure 2). We have revised up our 2014-16 growth forecasts (Figure 1), following this better-than-expected data.
Strong GDP data stands in sharp contrast to the continued weakness we see in private credit growth, which fell further in January to 5.2% y/y from 7.5% in December 2013. It now stands even further below the CBSL’s target of 16.0% for year-end. Historically, we have seen good correlation between industrial-sector growth and private credit growth (Figure 3). The recent divergence may be explained by the fact that corporates are using existing cash flow to increase production before borrowing more. Other indicators of domestic demand like import growth and new car registrations have also failed to show any meaningful increase (Figures 4 and 5).
We expect some of the divergence between GDP growth and other more timely proxy growth indicators to be reduced by a gradual improvement in the indicators. We also expect quarterly GDP growth rates to moderate from Q4 levels going forward.
Headline inflation fell further to 4.2% in February from 4.4% in January. It now stands at the lower end of the CBSL’s target range of 4.0-6.0%. This drop was due to a lower-than-usual 0.2% monthly increase in the headline index (on a lower-than-usual monthly increase in food and core inflation this February), versus an average monthly increase of 0.9% m/m in February in the past six years. Core inflation rose by 0.3% m/m, lower than the 1.1% m/m historical average monthly increase in February (again over the past six years). Core inflation of 3.1% y/y is extremely low, compared with the historical average of 6.1%, although it has inched up after reaching a trough of 2.1% y/y in December 2013. Slowly rising core inflation indicates that domestic demand is improving, albeit only gradually.
Food and beverage inflation rose 0.3% m/m, again lower than the six-year historical monthly increase of 1.1% m/m in February. At 0.9% y/y, food and beverage inflation stands significantly below its long-term average of 6.2% y/y (Figure 6).
There is a risk that food prices could rise sharply in the coming months, owing to reports of a drought during the December-February monsoon period. We will be monitoring this closely in the coming weeks, although we have not seen signs of sustainable food price increases in weekly food retail prices so far. Overall, we maintain our view that inflation is likely to remain relatively benign in H1 this year, rising gradually only in H2.
Earliest consideration for a policy rate change is Q3
The CBSL has used the improvement in GDP and inflation data to justify its decision to keep rates on hold. Policymakers have ruled out a change in rates for the time being, with both the CBSL’s Governor and Treasury Secretary indicating that it will maintain its status quo on rates for the next couple of months. This indicates that the CBSL wants to assess how the data evolves before taking any further steps; we think the earliest that a policy rate change will be considered is Q3-2014.
Our previous call was that if private credit growth fails to pick up to close to double digits and headline inflation continues to fall by end-Q1-2014, this could result in a further rate cut by the CBSL.
We now defer these conditions until end-Q2 given recent statements from policy makers, i.e., we think the CBSL will consider a policy change in mid-Q3 if data on private credit growth fails to show a pick-up by end-Q2 and inflation remains low. The caveat here is that the CBSL is likely to place higher importance on GDP growth data than private credit growth. Hence, if Q1-2014 GDP growth rates remain high (data for which should be available by end-Q2) and do not show any deceleration versus Q4-2013, the CBSL could choose to keep rates on hold, even if private credit growth is weak at end-Q2.
We remain neutral on rates
The rates market’s response to the monetary policy announcement has been rather muted, with T-bond yields remaining unchanged. We maintain our Neutral stance on T-bonds amid a stable policy rate environment. Foreign investor sentiment towards emerging markets is cautious as Fed tapering remains intact. Although foreigners have been net buyers of Sri Lanka Government securities in 2014 YTD (of c.$ 95m), they have sold c.$ 32m worth of T-bills and T-bonds so far in March. Foreign investors also continue to reduce duration by shifting their long positions from T-bonds to T-bills. However, as highlighted in On the Ground, 30 January 2014, ‘Sri Lanka – Waiting for the rebound’, we believe domestic factors – accommodative monetary policy and favourable demand-supply dynamics – remain supportive of T-bonds.
