Sri Lanka Rupee to Maintain Depreciatory Trend – Fitch

CEYLON TODAY | Published: 2:00 AM Oct 26 2021

We at Fitch Solutions have revised our forecast for the Sri Lankan rupee (LKR) to average LKR199.00/USD in 2021 from LKR202.00/USD previously. While this revision is to account for the fact that depreciatory pressures on the rupee have not been as strong as we have previously predicted, we continue to expect the currency to remain on a weakening path. Since our last update on July 2021, the LKR depreciated a further 1.2% against the US dollar to LKR200.98/USD and has averaged LKR197.63/USD over the first 10 months of 2021. 

As we have consistently pointed out, the weakening rupee can largely be attributed to Sri Lanka’s external financing challenge, alongside a widening trade deficit. Moving forward, we expect these factors to continue exerting depreciatory pressure on the rupee. From a technical perspective, the LKR is exhibiting a bearish bias. The unit continues to be weaker than both its long- and short-term moving averages (see chart above), suggesting a depreciatory trend over the medium term. From a fundamental perspective, our expectation for the Sri Lanka rupee to further weaken arises from the country’s external financing challenge. 

According to the Central Bank of Sri Lanka (CBSL), the country’s official reserve assets registered at USD2.5B as of end-September. This implies an import cover of 1.5 months, half the minimum recommended by the IMF. Meanwhile, the country has a total foreign principal debt obligation of approximately USD5.9B due in 2022, about half of which are payments on Sri Lanka’s International Sovereign and Development bonds. With the country’s 2022 foreign debt obligations exceeding current reserves, this will crimp the central bank’s ability to support the currency within the formal range of LKR199-203/USD. 

The elevated foreign-denominated debt-to-reserves ratio will also mean that Sri Lanka’s ability to refinance existing debts with fresh inflows from the capital markets will remain challenging given waning investor sentiments. While Sri Lankan authorities have, on October 1, proposed new measures under the ‘Six Months Road Map’ to address the country’s debt servicing ability, investors’ confidence did not see a marked improvement with the market price of external debt maturing in 2022 seeing a slight increase (see chart below). 

Meanwhile, the country’s fiveyear credit default continues to remain elevated, registering at 1610.95 basis points (bps), increasing by 188bps since our last update in July, and 1156bps from December 2019 (prepandemic). We expect the LKR to face additional pressures on the back of a hawkish tilt by the US Federal Reserves (FED). The FED has signaled its intention to start tapering its asset purchases over the coming months given an improvement in US labour market conditions alongside strong inflationary pressures domestically. 

Additionally, with members of the Federal Open Market Committee (FOMC) and market participants bringing forward their expectations for the start of the US rate hiking cycle to 2022 from 2023 previously, this will likely help strengthen the US dollar over the coming months, at the cost of emerging market currencies such as the LKR. While the CBSL will also gradually be normalising its monetary policy - we forecast a 100bps hike in policy rates by end-2022, persistently high risk surrounding external financing situation will mean that demand for Sri Lankan assets will remain broadly muted, informing our view that that the tightening of monetary settings in Sri Lanka will be insufficient in offsetting the rupee’s depreciation against the USD. 

In addition, we expect the currency to weaken due to worsening terms of trade on the back of higher commodity prices. The country’s trade balance in July widened for the fifth straight month, registering at USD607M. This brings the trade deficit for the first seven months to USD4.9B in 2021, higher than the USD3.5B in 2020 and USD4.3B in 2019. Trade deficit will likely remain wide throughout the year and even in 2022 on the back of higher commodity prices, which will be further exacerbated by the rupee weakness. 

The Food and Agricultural Price Index extended its growth in September, as the index registered at 130.0 points, representing a 32.8% y-o-y increase. Our Commodities team forecast Brent crude oil prices to average USD70.00/bbl in 2021 and USD67.00/bbl in 2022 from USD43.20/bbl in 2020. Meanwhile, we expect Sri Lanka’s export outlook to come in slightly weaker, given a potential cooling of US consumer demand over the coming months. The widening trade deficit will increase Sri Lanka’s external financing needs and put pressure on the country’s foreign exchange, thereby weighing on the LKR. 

Long-Term Outlook (six-to-24 months) While we have revised our LKR forecast for 2022 to average LKR206/ USD instead of LKR215.00/USD, our forecast continues to reflect our view for further depreciation of the rupee against the US dollar. Higher structural inflation relative to the US will weigh on the rupee. We forecast inflation in Sri Lanka to average 5.2% between 2022-2023, well above our average forecast of 2.2% over the same period for the United States. 

Higher inflation will weigh on the competitiveness of Sri Lankan exports in the international market and which will require further depreciation of the currency to preserve its competitiveness. In addition, elevated foreign debt repayment obligations over the coming years will continue to weigh on reserves, reducing the CBSL’s ability to defend its currency. Debt obligations from international sovereign bonds and Sri Lanka development bonds maturing in 2022 and 2023 come in at USD6.2B (about 241% of foreign reserves as of end September 2021). Given Sri Lanka’s persistent fiscal deficit and a weakening rupee, we expect repayment obligations remain elevated. 

Risk to outlook 

The risk to our currency outlook is weighed on the upside. According to the Six Months Road Map, the authorities are targeting an inflow of USD4.5B in Q421 and USD5.7B in Q122. Sources include bilateral financing and currency swaps worth USD1.5B each. Should that target be achieved, we expect investor confidence regarding Sri Lanka’s nearterm external debt repayment to be boosted given that this amount is comfortably greater than the country’s foreign debt obligation till end-2022. 

This will ease downward pressure on the LKR and allow the CBSL to better defend the currency. An improving tourism outlook on the back of relatively high vaccination rate in the country (59.5% of the population is fully vaccinated) alongside a decrease in cases (the 7-day moving average number of cases as of October 17 is at 752, significantly lower than the peak of 5961 on August 30) will also bolster the country’s foreign exchange inflow, achieving a similar effect. 

(Above commentary is published by Fitch Solutions Country Risk & Industry Research and is NOT a comment on Fitch Ratings’ Credit Ratings. Any comments or data are solely derived from Fitch Solutions Country Risk & Industry Research and independent sources. Fitch Ratings analysts do not share data or information with Fitch Solutions Country Risk & Industry Research).

Key View  

• We at Fitch Solutions have revised our forecast for the Sri Lankan rupee to average LKR199.00/USD in 2021 (from LKR202.00/USD) and LKR206.00/USD in 2022 (from LKR215.00/USD) as depreciatory pressures on the LKR have not been as strong as we previously thought. 

• Nevertheless, we continue to expect the currency to remain on a depreciatory trend due to Sri Lanka’s challenging external financing situation, tighter US monetary policy, alongside worsening terms of trade.

• Over the long-term, higher structural inflation relative to the US coupled with still elevated foreign debt repayment will drive the LKR lower relative to the US dollar. Short-Term Outlook (three-tosix months)  

CEYLON TODAY | Published: 2:00 AM Oct 26 2021

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