ECONOMYNEXT – Sri Lanka’s Coronavirus crises and an exit of expatriates have lowered rents but real estate is an attractive medium to long term play amid money printing and low interest rates, and the exit from current policy have to be watched, industry officials said.
“There is pressure on yields because the rental markets on the residential space has slowed down because we have had fairly large exit of expats,” Nayana Mawilmada, Executive Vice President of John Keells Holdings, said in an online forum organized by Sri Lanka’s Echelon Magazine.
“And the expats were actually keeping the market, particularly in the CBD (central business district) propped up,” he said.
“The trend of expats trickling out, at least from my vantage point, has been gradual since Easter attacks and it has been acute since Covid-19.”
A hit on tourism and retail had also compounded the problem.
“The yields I think will continue to suffer and this will be the same or in a lesser way in the office category because the leases tend to be longer, so people will write out but you are seeing a bit of pressure on that front,” Mawilmada said.
“And then of course the retail industry has been hit fairly badly because of tourism being hit. The pressure on yields is going to be constant in the current environment in the short term.”
“Sales velocities have faltered to an extent and I think by the end of the day, you are going to have some blood on the streets.”
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Sri Lanka’s interest rates had fallen after private credit collapsed from April amid lockdowns despite an expansion of the budget deficit.
Asset Price Inflation
The central bank in addition also printed money, leading to excess liquidity in the banking system as reserve money expanded.
“If you look at what central banks have done globally at the start of Covid-19, they went through a massive period of monetary easing and quantitative easing,” Naveen Gunawardane, Managing Director at Lynear Wealth Management said.
“That has done two things. It had brought interest rates down and you do have quite a bit of money that has been printed.
“What this basically means is that investors have had to reassess their asset allocations.
“The asset allocations you had at the beginning of the year are no longer valid and a lot of investors had to reassess and increase allocation in risk assets. In Sri Lankan context when you talk about risk assets, it is really equities and real estate.”
He said Sri Lanka’s long term interest rates may fall from historic highs seen in the past.
“In the US a ten year bond was at 15 percent in 1980, in UK the ten year gilts were at 10 percent in the 1980s,” Gunawardane said.
“If we assume that Sri Lanka’s economy is going to evolve then we should expect our interest rates to come down structurally.
“Having said that as far as the current cycle is concerned, we are currently at the bottom of it,” he said.
The US had high interest rates after the collapse of the Bretton woods system 1971 and the Fed exited the gold standard.
But rates and inflation had been going up after World War II as Keynesianism and output gap targeting worsened, de-stabilizing monetary policy critics say, which reached its climax under Governor Arthur Burns leading to the collapse of the Bretton Woods soft-peg system (targeting gold and targeting rates).
The Fed struggled to have an alternative anchor for monetary policy until Paul Volcker tightened policy and brought inflation down and strengthened the dollar.
All countries that have monetary instability and conflicting anchors (soft-pegs involving targeting a reserve currency and policy rates) in particular tend to have high interest rates as currencies collapse compounded by high reserve ratios (where they are used).
As conflicting monetary and exchange rate policies are eliminated towards more credible pegs or true floats with low inflation, interest rates plunge.
Before the activist monetary policy in the 1960 led to the collapse of the Bretton Woods and the final exit from gold standard, the US and also Sri Lanka had low interest rates, students of economic history say.
Sri Lanka (Ceylon) also had low rates throughout its currency board period from 1885 to 1950 when monetary policy was anchored to silver.
Rates started to rocket as the rupee collapsed after the economy was re-opened after 1977 without reforming the central bank.
Asset Price Inflation
Similar trends had been seen in the past. When interest rates fall, the present value of long term assets goes up.
“If we go back to 2011 we saw a lot of capital going to the real estate market across the board, at that time too interest rates were very low,” says Chandaka de Soysa, founder and Chief Executive of Acquest, a real estate advisory.
“We saw capital values and interest values go up as high as 500 percent for certain types of property.”
The 2011 stock and property bubble ended in a currency collapse that drove the rupee from 110 levels to 130 to the US dollar.
Since property is a long term asset, short term falls in rental yields have to be taken in context.
“A majority of investors looking at buying an apartment or property, one of their primary concerns at the point of making that investment is not looking at the rental yields.
“It is primarily driven by owning a hard asset and investing in something they understand. When people invest in real estate it is important to take a medium to long term view.”
In the high end apartment prices have corrected, which also tends to balance out rental yield.
There inquiries about hotel and other properties.
There is demand for more affordable apartments industry officials said. Some of the high end projects were conceived when post-war economic prospects were brighter.
Other analysts have pointed out that protection given to steel and other building material factories is a key factor in Sri Lanka’s high construction costs which is making tourism, exports and real estate in general lag behind East Asia and the rest of South Asia.
Now protection is also spreading to cement.
But with high urban sprawl and traffic congestion city center may remain in demand until a mass-rapid-transit system is built.
“Investors who really look at this medium term to long term and make very calculated kind of decisions will do very well,” Mawilmada said.
“If I were to give a forecast, given where we are on the macroeconomic factor and also the way we seem to be pivoting on mass transit versus vehicular traffic and transport, I think that you will see a much bigger rally on the center of the city until we start to pivot on to mass transit again.”
Exit Strategy
Though Sri Lanka printed money despite having a pegged exchange rate, countries like Vietnam have avoided it, analysts say. When private credit falls, and bond yields fall, the government can borrow more and run a deficit easily without printing.
Gunawardane said inflation may not be an immediate threat, but investors will have to watch how excess liquidity is taken out next year.
“From a demand point of view with import controls in place I don’t see inflation rising in the next few months,” Gunawardane said.
“Next year, is a different story. We have quite a bit of liquidity that has been pumped in.”
He said how Sri Lanka gets out of current import controls will have to be watched.
Sri Lanka currently has weak private credit, though there was a pickup in August.
Many loans maybe 40 to 50 percent are under moratorium and are rolled over as performing without any cash flow movements, the effect of which is not clear and is not comparable to previous episodes, economic analysts who closely track monetary policy say.
Excess liquidity, in general, tends to drive imports, reducing domestic inflation (not asset prices which cannot be imported) but puts pressure on the currency or forex reserves if the peg is defended after printing, analysts say.
If the peg is not defended after printing and increases in credit, like in March – under a so-called flexible exchange rate – the currency can rapidly fall analysts say altering the price structure of the economy and drive credit for working capital in a vicious cycle even as total economic activity and trading volume falls.
But import controls may push up prices especially of traded commodities amid import controls. But when credit is slow or negative overall consumption is also low and excess liquidity tends to get piled up within the central bank.
Sri Lanka also has a debt repayment problem and credit downgrades and falls in sovereign bond prices have shown higher perceptions of investor nervousness.
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Analysts have warned that Sri Lanka has a Prebish-Triffin or Latin American style central bank, which tends to generate a high degree of monetary instability. (SB-Colombo/Oct26/2020)