Bond yields on the Colombo Stock Exchange expected to be bullish over medium term

Ahead of a $1bn sovereign bond maturing in January 2019, Sri Lanka went through a major political crisis during the fourth quarter of 2018, which led to an extensive legal battle. Despite economic data indicating no serious threat to inflation and private sector credit, the heavy liquidity shortage in the market and the uncertain political environment resulted in a spike in domestic yields by 200-250 basis points (bps). Credit ratings agencies Moody’s, Fitch and Standard & Poor’s downgraded the country by one notch, citing refinancing risks and an uncertain policy outlook.

Foreign reserves also trended downwards, with high foreign debt payments in the second and third quarters of 2018, and continuous outflows throughout the last half of the year, primarily affected by the interest rate hikes by the US Federal Reserve. In November 2018 the Central Bank of Sri Lanka (CBSL) addressed the liquidity shortage, reducing the statutory reserve requirement by 150 bps to neutralise the impact. Policy rates were sharply expanded as the standing deposit facility rate was increased by 75 bps and the standing lending facility rate by 50 bps. Despite this, foreign outflows further accelerated, and delays in negotiating new loans and raising funding due to the political situation resulted in a further dip in foreign reserves, which depleted below $7bn by December 2018.

Inflation & Credit

With heavy depreciation of the rupee in 2018, inflation may have an adverse impact during 2019, rising in the first three quarters of 2019 to peak at 7%, before decelerating in the fourth quarter. Inflation will be managed at mid-single digits throughout 2019, with the annual average at 5.3%. Despite higher credit growth in the fourth quarter of 2018, following the rise in interest rates and implementation of Basel III requirements, private sector credit will remain in control and grow by a projected 15% in 2019.

Rebuilding Reserves

Rebuilding reserves will be key to the stability of the economy and confidence of investors. The CBSL is under significant pressure to accelerate negotiations to roll over the debt, with $500m in sovereign bond maturities due in April 2019, following the maturing of $1bn US dollar bond in mid-January. Increasing risk, the ratio of foreign reserves to foreign currency repayment has fallen to 1.1, with $6.5bn of foreign currency debt payments slated for 2019. Raising dollar debt, primarily via development bonds and subsequently tapping international capital markets through sovereign bonds in the third and fourth quarter of 2019, is the roadmap for the year.

Looking Ahead

A slowdown in US growth expectations is likely to lead to a delay in further rate hikes in the US, providing some breathing space for emerging markets and currencies. With emerging markets providing attractive yields and valuations coupled with the slowdown in the US, global fund flow is reversing back towards emerging markets, which is favourable for Sri Lanka. With Sri Lanka focusing on reviving the IMF agreement and rebuilding reserves, the environment is expected to improve in the last half of 2019.

Despite this, divergent views among governmental bodies may continue to adversely affect and delay policy decisions up until the elections that are scheduled to take place before January 2020. As of early 2019, six provincial council terms have expired, and the remaining three will do so by April and October, which may prompt elections for the provincial councils as well.

Bullish Yields

Most economic indicators will likely improve beyond the first quarter of 2019, possibly with a stronger foreign currency reserve, which will build confidence in the market. The slow growth prevailing in the country will likely influence the CBSL to cut rates over the year by 25 bps in the second and fourth quarters. In line with this roadmap, the CBSL will likely issue a sovereign bond in the third quarter, while concentrating on raising funds through Sri Lankan development bonds and bilateral loans or swaps during the first quarter. These moves should further build positive sentiment in the bond market later in the year.