Last month's hike in policy rates by 50 basis points and the government's decision to allow the currency to freely float have raised real concerns on economic growth and the stock market in general, analysts say.
Deposit rates to rise
Analysts said that the average deposit rates which are near 7% are believe to rise at a slower pace facilitating bank and finance sector companies to fatten their net interest margins.
While they said that moving towards a much leaner free float would always improve transparency and drive real growth, on the negative there would be higher volatility especially when large import bills are serviced.
Economists noted that the weakening currency would bring in another set of challenges for Sri Lanka which is a consumption driven economy. "With the fuel prices expected to be jacked up, the cost of imported food items such as wheat, sugar, milk powder, etc will also rise in price," an economist said.
He said that the increase in interest rates will see an exit from the market as savings become more attractive due to high interest rates that are offered by all financial institutions. Analysts noted that as cost of borrowing becomes more expensive there will be a further reduction in money inflows into the market. "All institutions in the economy will face difficulty due to high cost of borrowings that will increase the finance costs and with imported inflation the profit margins will become thinner and further reducing the earnings of companies," the analyst said.
He noted that the real wages have currently reduced, and that most companies will benefit by this in the short run. However many say that the indices will remain at similar levels or could face further downward pressure, but the current levels seem to be holding up in the market for the moment.
Rate changes had to happen
According to some analysts, the Central Bank (CB) increasing policy rates and flexing exchange rates had to happen and it was more a matter of time. "Low interest rates had fuelled a credit growth that was primarily import-driven. This drove out liquidity in the market. In addition, the huge import bill fuelled by the credit growth in addition to the much higher reliance on thermal energy (due to a drought last year) imposed considerable pressure on exchange rates," Deshan Pushparajah, Head of Capital Markets, Capital Alliance said. He added that increasing policy rates will drive up interest rates and reduce demand for credit but, he noted that this will not be very positive for the financial services sector which, with increased competition would have had to rely on volume growth this year. He added that the increased rates could also drive down sales in the consumer discretionary sector which is generally credit driven (eg vehicles, etc.).
Danushka Samarasinghe, Director, TKS Securities (PVT) Ltd noted that curbing excessive credit growth through interest rate hikes is a positive rather than having to keep interest rates artificially low and resort to excessive money printing. "Higher interest rates would dent GDP growth rates, though over the medium term the economic health of the country would improve," he added.
Many say that the increased policy rates also increases the hurdle rate for investing the equity market. "This could render the market relatively unattractive vis-a-vis fixed income instruments and hence has an overall negative impact on investors and the recent market downturn is primarily to do with that," Mr. Pushparajah added.
Analysts also added that the devalued rupee will have a mixed impact on the listed companies. "Export companies and import substitution companies will benefit with the higher value for the dollar. Low margin commodity companies would potentially benefit the most out the devaluation. On the other hand, import related companies will see sales potentially slowing down to higher pricing/ lower margins," the analyst said.
However, the foreigners were adopting a wait and see approach to the devaluation. "Now that this has happened, bargain hunting foreign investors should probably come back into the market," Mr. Pushparajah noted.
Analysts also say that the credit ceiling will potentially be a serious drawback to the banks. They say that with a ceiling imposed, banks would attempt to improve their margins and hence become more actively involved in the personal loans space (where the margins are much higher - credit cards, etc).
"This could result in lower asset quality for banks this year whilst also crowding out the middle level corporates which cannot afford to pay the same margins on business loans," Mr. Pushparajah noted.
However, he also said that the ceiling should help the macro economics of the country by checking the huge credit growth and reducing the demand for consumer money.
Listed firms attractive
Analysts said that the markets will also be affected by this due to the potentially higher interest rates/ limit impositions on margin lending. Mr.Samarasinghe noted that last year the Colombo Stock Exchange became expensive based on valuations and having nosedived since its peak, the market remains relatively attractive given its growth potential.
While the foreign inflows have improved over the last two weeks, analysts said that the valuations of the companies are finally looking attractive again on a relative basis. "In addition, with the settling down of the European situation, most emerging markets across the world have seen money flowing back their way, so it's not a unique situation," Mr. Pushparajah pointed out.
Analysts said that during the past few months foreigners were however, adopting a wait and see approach due to the impending rupee devaluation. "Now that that has happened, my guess is that you will see some good money flowing in this year," Mr. Pushparajah added.
Mr. Samarasinghe noted that given the overall macro positive with growth intact and the weakening of the rupee, foreign portfolio investments are targeting Sri Lanka. Further the weakening of the currency beyond Rs 120 per US$1 is more of short term scenario resulting due to the possibility of foreign portfolios invested in the domestic bond market pulling out, Mr. Samarasinghe added. "However we believe the foreign fund inflows would be sufficient to weather any sudden outflows although in the short term high exchange rate volatility and pressure on the rupee should be expected." He further said that in the eyes of the foreign investors Sri Lanka is a growth story, having recorded 8% plus GDP growth rates in the past two years. "Amidst the global economic slowdown we believe the country would record +6.6% real growth in 2012 which provides sound justification for their view," he said.