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Frontier Economic Monthly - September 2016

​Executive Summary

• -Our preliminary end-2017 view sees a decline in interest rates and a largely stable LKR (against the USD) with just a bit more room for further depreciation by the end of 2017.
• -Key assumption of the view is an improvement in fiscal situation next year particularly given the IMF presence.
• -Overall, our initial outlook for 2017 is one of relative stability compared to shock adjustments we have seen in recent years.
• -However, we expect to reassess these views once the Budget 2017 is presented to see if there is a need for a material change in our views.
• Focus 1 – The Central Bank of Sri Lanka (CBSL) is on the process of adopting an Inflation Targeting model for its monetary policy framework. In this Focus, we take a closer look at what this framework is, its advantages and more importantly, limitations Sri Lanka would face in adopting the model.
• Focus 2 – The Ministry of Finance recently released data on government’s fiscal operations for the first six months of 2016. Here we have analyzed the fiscal performance in the first half of the year, along with a further analysis on Tax revenue performance during the first four months of the year.
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• In Our Report

Frontier is already gearing up for 2017 and we have updated our end-2017 views on rates and LKR.

Before getting into the updated view, here’s a small reminder on our views on rates given for a 12-24 month horizon in April this year

We have a positive long-term expectation on interest rates at present. Our base view, with a probability of 50%, is that financial stability will return to the economy within a 12 to 24 month horizon where rates across the board will be lower by at least 100 BPS from current levels. [From Shock to Positivity, Rates bulls in our 12-24 month base view – 4^th April 2016]

In line with our view we saw a material decline in treasury rates in recent weeks, with the 4 year and 10 year bond yields falling about 100 and 95 basis points (BPS) respectively from the levels seen in April this year. However, the 12-month T-Bill rate has risen around 25BPS within the same period.

Taking into account policy and other developments that have taken place since then, we are now outlining what our view of financial stability will mean for rates and the LKR for end 2017.

Now our updated base case view in short;

Similar to our view given in April, we continue to have a positive view on rates for 2017. We expect to see a decline in interest rates and a largely stable LKR (against the USD) with just a bit more room for further depreciation by the end of 2017.

Our base case of 45% probability expects the 12-month T-Bill rate to decline and end 2017 between 7.5% and 10.0%. (Mid-point of 8.8% by end 2017)

Our base case for the LKR – again with a 45% probability – sees the currency depreciating a bit further, ending 2017 between Rs. 148 and Rs. 154 against the USD. (Mid-point of Rs. 151 against the USD by end 2017)

More details on the base view;

Why a positive tone?

For the past couple of years, we have been calling for a shock adjustment in rates and/or LKR given the pressures in the economy, particularly in terms of imbalances in the current account and fiscal deficit, loose monetary policy which elevated aggregate demand exerting pressure on external balances, and external debt outflows. In line with our views we saw interest rates adjusting upwards and LKR weakening against the USD.

While these concerns still remain, we feel that the monetary tightening measures taken and the IMF program put in place (if followed appropriately) could drive the economy into a relatively stable path next year. The positive sentiment around these developments and the general optimism around emerging market economies we are seeing now could ease the pressure off refinancing requirements limiting the need for further adverse adjustments in rates and LKR.

So what are the key assumptions of the view?

A key assumption in our base case is that we would see an improvement in fiscal conditions next year with the IMF presence playing a role in encouraging key reforms and stabilizing the fiscal situation. Given this being a key assumption, we will be reassessing these preliminary views once the budget for 2017 is outlined to see if it is in line with our expectations or if a material change in our assumptions and views is required.

The base view also factors in that there will be no further monetary tightening.

While these assumptions – if materialized – could see an improvement in indicators, the reason we are expecting a limited decline in rates and further depreciation in the LKR is to account for possible volatility caused by global uncertainties. Global headwinds such as rising interest rates trajectory with the US expected to tighten its monetary policy and the ensuing effects on emerging markets could play a key role in limiting the positive adjustment in these variables.

Are there any alternative scenarios that can play out?

Yes.

There are scenarios where we can see an adverse adjustment in rates/LKR and where there will be a more positive adjustment in these variables compared to our base view. In the attached report you can find further details (the ranges, probabilities and assumptions) on these alternative scenarios. Please see pages 22-25.

The attached report contains detailed information on our end-2017 views for 12-month T-Bill rate, 10-year T-Bond yield and the LKR along with further details and charts on the Focuses mentioned above and other important macroeconomic data points.

Written by Ashini Samarasinghe

Contributors: Nirukthi Kariyawasam