A research report by a group of strategists and economists at global banking giant HSBC is encouraging the buying of Sri Lankan government bonds and treasury bills.
Titled "Pax Sri Lanka: Buy bonds, long LKR on near-term macro-financial stability", the report, authored by HSBC's Virgil Esguerra, Frederic Neumann, Dominic Bunning and Prithviraj Srinivas, states "HSBC recommends re-establishing longs on T-bills and Sri Lankan government bonds (SLGBs). Although nominal yield levels on Sri Lankan bonds have declined, reduced event risks - coupled with a benign macroeconomic and policy outlook - should keep bond investments stable over a six-month holding period. Moreover, HSBC expects capital inflows to offset Sri Lanka’s chronic current account deficit in the near term, contributing to continued modest appreciation in the Sri Lankan rupee (LKR) from 113 to 111 by year-end". However, the indicates a preference for "short-dated T-bills and bonds maturing less than two years due to relatively rich valuations on long-end SLGBs".
This is after a "buy" recommendation was withdrawn by the bank several months ago coloured by speculation about parliamentary elections and the 2010 budget as well as the International Monetary Fund (IMF) decision to postpone the third tranche of its Stand By Agreement to Sri Lanka. In fact, HSBC's new position specifically acknowledges the role of a "decisive" victory by the ruling UPFA coalition; balance of payment support due to the release of the third tranche of US$ 408 million by the IMF; as well as "the administration’s intention to gradually narrow the fiscal deficit (FY10 target: 8% of GDP, versus 9.8% in FY09). The FY10 budget plan assumes 7%-growth in expenditures and 17%-revenue growth based on lower interest payments, improved economic growth and tax rationalisation measures. The budget plan’s credibility is boosted by the government’s recent efforts to reduce subsidies and control public sector wages".
Further outlined in this report is that long term inflation is expected to be fixed: "HSBC Economics forecasts inflation to average 6.5% over the next 12 mths (versus a three-year average of 12.8%) due to improved agricultural production, slower public sector credit growth and low global commodity prices. Near-term, an increase in the price of key consumer items (e.g. milk powder, cooking oil) could add short-term inflation pressure". It is also predicted that the Central Bank (CB) of Sri Lanka will not cut interest rates as private sector credit growth increased along with greater business and consumer confidence.
Additionally, the report indicates that the "foreign appetite" for these instruments will remain strong and close to the 10% investment limit outlined. This is because of "attractive nominal yields (6mth and 12mth T-bills weighted average yields of 8.90% and 9.20%, respectively)". However, fresh inflows in this area are dependent on increased numbers of outstanding bills and bonds, which, based on the government’s plans, "HSBC estimates outstanding bills and bonds to increase LKR200-250bn this year, implying that foreigners will only be able to raise net holdings by LKR20-25bn over last year". Also noted is that this 10% limit on foreign investors is unlikely to be increased in the future.
While the CB estimates a Balance of Payments surplus of US$ 200 million, HSBC's position is that "the capital account is most likely to do all the heavy lifting in erasing the persistent deficit pressures in the current account". It also notes that "[funamentally], the LKR is vulnerable due to its twin - current account and fiscal - deficits". It however suggests that capital outlook in the near term has been improved due to investor confidence and the IMF's Stand By facility, saying "HSBC Economics expects capital inflows to sufficiently offset the current account deficit".
The report also asserts that the "current account is likely to deteriorate further in 2010 as infrastructure spending and reconstruction activities gain in strength. Broad policy measures aimed at increasing private consumption would push-up import requirements as well. Unfortunately, the downward pressure on the trade balance due to strong imports growth would not get a reprieve from growth in exports... The capital account will stay in surplus this year supported by strong growth in portfolio inflows, FDI, overseas aid and government borrowing. HSBC expects to see the capital account post a surplus of nearly USD2.2bn". It also states that "[overall, HSBC estimates a current account deficit of USD2bn (4.4% of GDP), slightly wider than official estimates (USD1.8bn) but much larger than in 2009 (USD300m)".