Standard Chartered Research Report Sees Slower Growth in 2012. "On the Ground: Sri Lanka – A Challenging Year Ahead"

09th January 2012, www.island.lk

The uncertain policy environment regarding the exchange rate with the Treasury and Central Bank pulling in opposite directions, and the recently passed expropriation law, could deter investors from making their crucial inputs to the economy which is expected to see slower growth this year, Standard Chartered Bank says.

A research report titled ‘On the Ground: Sri Lanka – A Challenging Year Ahead’, authored Standard Chartered Bank Colombo Office Economist Samantha Amerasinghe said the economy would grow 7.5 percent this year, down from 8.3 percent in 2011, largely due to weak global economic environment.

Commenting on the Road Map: Monetary and Financial Sector Policies for 2012 and Beyond released by the Central Bank last week, the report said it (the road map) disappointed in not addressing the external-sector challenges posed by the deepening current account deficit and falling foreign currency reserves.

The Central Bank said the economy could expect an inflow of US$ 25 billion this year. Central Bank Governor Ajith Nivard Cabraal told The Island Financial Review last week that a significant portion of these would materialise within the first quarter and significantly reduce the pressure on the balance of payments. However, Standard Chartered Bank does not seem to share this optimism, as do most other market players (see The Island Financial Review January 5, 2012).

"Sri Lanka’s balance of payments is likely to come under significant pressure this year. The year-to-date trade deficit widened to US$ 7.73 billion as of end-October 2011, surpassing the record full-year deficit of US$ 6 billion in 2008. With investment and intermediate goods dominating the country’s import basket due to the strong post-conflict infrastructure push, the Central Bank is under mounting pressure to further depreciate the Sri Lankan rupee (LKR) to curtail rising import demand. However, it maintains that ‘a large volume of foreign currency inflows" are expected soon. We have factored in one more currency devaluation, taking the LKR to 115.8 against the US dollar in Q2-2012, in response to the bleaker trade outlook. Since most of Sri Lanka’s imports are necessary items, further LKR depreciation could potentially deter growth; hence, the central bank is likely to hold off on such measures unless capital inflows fall short of expectations," Standard Chartered Bank said.

"The central bank has been criticised for its current strategy of defending the LKR at the expense of its FX reserves in the face of rising import demand. Foreign exchnage reserves are estimated to have fallen sharply to US$ 6 billion (four months of imports) as of end-2011 from US$ 8.2 billion as of end-August.

"In its policy roadmap, the Central Bank of Sri Lanka (CBSL) estimated US$ 25 billion of foreign inflows in 2012. This appears optimistic given the gloomy external environment, in our view. Projected foreign capital inflows are comprised of US$ 12.5 billion of export revenues (up from an estimated US$ 10.5 billion in 2011), US$ 2 billion of FDI (doubling from 2011), US$ 6.5 billion of remittances (a 25% y/y increase), and US$ 1.2 billion of tourism inflows.

"The CBSL’s export growth projection of 19% for 2012 appears ambitious given that the US and Europe are Sri Lanka’s key export markets, and that competitor countries have also depreciated their currencies. Our export revenue growth forecast is more conservative, at c.10%; we expect FDI to fall short of the CBSL’s forecast by US$ 0.5 billion amid the prevailing global uncertainty. The passage of the expropriation bill in November 2011, which nationalised certain assets of underperforming private enterprises, may also deter investors, as it undermines policy consistency.

"Remittance inflows should continue to grow at trend levels, despite current tensions in the Middle East; the central bank estimates a 27% y/y increase by end-2011. A greater focus on migration of skilled workers, government negotiations to increase the average wages of overseas workers, and a diversification of overseas employment markets seem to be paying dividends. Given the estimated US$ 850 million of tourism earnings generated in 2011, we believe the CBSL’s US$ 1.2 billion projection for 2012 is realistic, particularly since Sri Lanka will host the International Cricket Council (ICC) Twenty-20 cricket tournament this year. However, to achieve this target, tourist arrivals from Asia must also offset the potential decline in arrivals from Western Europe.

"The central bank announced in its roadmap that it was keen to negotiate a follow-up surveillance programme with the IMF after its existing USD 2.6bn loan programme ends in May 2012. In our view, such a programme would be positive for investor sentiment and would appease the private sector. However, the central bank’s stance of continuing foreign exchange intervention may not be viewed favourably with the IMF. Furthermore, the central bank?s view that BoP pressure is temporary contradicts the Treasury Secretary’s view that external imbalances must be addressed, and highlights policy differences that have emerged since the 3% LKR devaluation in November 2011. This concerns us, as an uncertain policy environment could negatively affect investor sentiment," the Standard Chartered Bank report said.

"The global challenges of a faltering US recovery and the ongoing euro-area debt crisis continue to undermine confidence in global financial markets and remain the biggest impediments to Sri Lanka’s growth in 2012. While the key growth drivers of tourism, remittances (now Sri Lanka’s biggest foreign exchange earner, estimated at USD 5.2bn in 2011), and construction continue to underpin the economy, we believe sustaining growth at 8.0% levels will be challenging. We maintain our 2012 growth forecast of 7.5%. We highlight key concerns below that support our weaker growth outlook:

(1) The US and Europe are Sri Lanka’s biggest export markets and together account for c.56% of exports. Reduced demand from both markets in 2012 is likely.

(2) Given the debt crisis in Europe, growth in tourist arrivals (close to 35% y/y as of end-November 2011) is likely to slow unless increased arrivals from Asia compensate. Western Europe currently accounts for 37% of tourist arrivals to Sri Lanka, followed by India (20%) and East Asia (11%).

(3) The ongoing political turmoil in the Middle East may have longer-term implications for remittance inflows via lower migration of Sri Lankan workers to the region. It could also affect Sri Lanka’s main agricultural export, tea, due to faltering demand in 2012. Tea exports to the Middle East and North Africa comprise 55% of Sri Lanka’s total tea exports.

(4) If the EU decides to ban crude oil imports from Iran, this could put upward pressure on global crude oil prices and have severe repercussions for Sri Lanka’s balance of payments (BoP), as petroleum makes up c.25% of the country’s import bill. We are leaving our crude oil forecasts for 2012 unchanged for now – ICE Brent at 95 USD/barrel (bbl), NYMEX WTI at 85 USD/bbl, and Dubai at 93 USD/bbl in Q1 – as we believe Iran’s exports will continue to reach the global oil market. As a result, we maintain our Q1-2012 forecast for Sri Lanka’s GDP growth at 7.5%," Standard Chartered Bank said.

Related Info :

• Central Bank Unveils a Robust Roadmap for Sri Lanka for 2012 after Recording the 2nd Consecutive Year of over 8pct Growth

• Sri Lanka's Economy to Grow at 8pct in 2012 with a New Deal with IMF