Sri Lanka fundamentals are deteriorating a bit, and so its assets are likely to underperform for the time being. However, political risk is minimal and we believe the current government will continue to liberalize the economy and maintain orthodox policies.
The January presidential election ushered in a new coalition government led by President Sirisena. Then, parliamentary elections in August 2015 led to a national unity government consisting of the two largest parties, the United National Party and the Sri Lanka Freedom Party. The next elections are not due until 2020.
The end of the increasingly autocratic 10-year rule of President Rajapaksa was a welcome development. While the decades-old civil war was finally ended during his first term, his government was accused of potential war crimes. Rajapaksa was also dogged by corruption and cronyism charges. He tried unsuccessfully to become Prime Minister in the August general elections, but did win a seat in parliament.
Relations with neighboring India have improved. Also, the domestic security situation remains favorable, as the rebel LTTE (Tamil Tigers) was all but wiped out under Rajapaksa. The World Bank currently ranks Sri Lanka at 107 (out of 189) in its “Ease of Doing Business” studies, up from 113 last year.
The economy is slowing. GDP growth is forecast to slow modestly to around 6.5% in 2015 and 2016 vs. nearly 7.5% in both 2013 and 2014. GDP rose 4.8% y/y in Q3, slower than expected, and so there are downside risks to these growth forecasts.
Price pressures are picking up, with CPI rising 3.1% y/y in November. This is the highest rate since September 2014, and suggests that the next move in the policy rate is up. The central bank has been on hold since March, when it cut the policy rate by 50 bp to 6.0%.
Fiscal policy is a key concern. The budget deficit exceeded the target by one percentage point of GDP last year (at around -5.5%), and was the first year since 2009 that it did not improve as a share of GDP. It is seen widening to -6% of GDP in both 2015 and 2016, but the risks are tilted to the upside.
The IMF has warned that revenues will likely drop in 2016 as one-off measures expire, adding that tax reform to broaden the tax base is long overdue. Unfortunately, the 2016 budget was disappointing as it failed to outline a sustainable deficit-reducing trajectory. Still, our own sovereign ratings model shows Sri Lanka as a BB+/Ba1/BB+ credit, suggesting upgrade potential for actual ratings of B+/B1/BB-.
The external accounts are in decent shape. Lower oil prices will help reduce imports, but there is a risk that this will not outweigh downward pressure on exports. As the central bank tried to support the rupee, foreign reserves fell over the course of 2014 to below $6 bln in early 2015. They have since rebounded to nearly $7 bln in September, as the central bank stepped back from its support. This level is still a bit low. However, Sri Lanka successfully completed an IMF program in and is currently in Post-Program Monitoring. As such, it could go to the agency for help if needed.
The rupee is a managed currency, and has fallen only -9% YTD vs. USD. It is subject to sharp periodic adjustments, however, though falling foreign reserves have led to less management and a greater role for market forces. The IMF noted recently that “Exchange rate flexibility will be an important element in maintaining an adequate level of central bank foreign exchange reserves.” We see continue LKR weakness ahead, but with low risks of capital controls at this point.
Sri Lankan equities have outperformed slightly within Frontier Markets. MSCI Sri Lanka is down -17.2% YTD, and compares to -18.8 YTD for MSCI Frontier. This outperformance could ebb a bit, as growth slows and the central bank likely begins a tightening cycle in 2016.
Sri Lankan bonds have not done well this year. The yield on 10-year local currency government bonds is up about 130 bp YTD. This is in the underperforming group. Compare this to the worst performers Brazil (+359 bp), Turkey (+263 bp), Colombia (+175 bp), and Peru (+168 bp). With inflation likely to rise and the central bank likely to tighten, we think Sri Lankan bonds are likely to continue underperforming.