Low borrowing rates and tax cuts have potentially transformed the economy. What does it mean for the government securities market and for investment strategy?
Sweeping tax cuts and a moratorium on small business loans capital repayments will potentially drag Sri Lanka’s economy out of the doldrums. Apart from the government’s fiscal stimulus, the economy will potentially transform with the Central Bank reducing monetary policy rates; lower lending rates will lift credit growth and consumption. General elections slated for April 2020 will likely enhance political stability which is also growth positive.
“The heavy tax cuts and the lower interest rate regime are expected to boost consumption and investments, improving GDP growth. However, the acceleration is likely to take place towards the second half of 2020. Thereby, we expect growth to reach 4.1% during the year,” First Capital Research said in its flagship ‘Strategy Report 2020: Fiscal loosening weakens 2H2020 outlook’ released in February at a well-attended business forum in Colombo.
First Capital is a listed investment bank in Sri Lanka. The economy will continue to pick up steam heading into 2021 but will slow down during the second half.
However, economic growth for 2021 will be an improved 4.3%, a five-year high, the investment house said. What does all this mean for an investment strategy? With the economy improving and interest rates trending downwards, equities are looking more attractive than in recent years. The heavy tax cuts and the policy rate cut are likely to be an added boost for company earnings. With attractive multiples, First Capital has upgraded its equities outlook and is bullish that the Colombo stock exchange’s All Share Index will reach 6,500 points by June 2020 and increase to 7,500 points by end December 2020, significantly higher than its earlier forecast of 7,000 points.
Equities, however, are risky and cannot match the security offered by government treasury bills and bonds.
First Capital recommends an investment strategy of holding government securities with shorter tenures because yields will likely pick up towards the second half of 2020. Pressure on bond yields to rise will mainly come from the government’s increased domestic borrowing requirement, pushing the yield curve higher by 50-100 basis points. Market borrowing rates will also trend slightly upward. Bank prime lending rates usually lag the five-year bond yields by six months. The Central Bank recently imposed lending caps on banks to force interest rates down. The average weighted prime lending rate (AWPR) for the banking sector has bottomed out at around 9.5% and will slightly increase in the second half of the year. The fiscal stimulus will make it difficult for the government to manage the budget deficit as tax revenues decline.
Although rupee debt repayments remain low in 2020, a potentially high budget deficit is likely to be created with the hefty tax cuts. The high budget deficit is likely to push the rupee debt borrowing requirement also higher. The trade deficit may also grow wider towards the second half of 2020 amidst the possible rise in consumer demand possibly leading to a high level of consumer imports, pressuring the foreign reserve and the rupee,” First Capital says. There are higher external debt repayments due including a $1 billion sovereign bond maturing in September 2020. First Capital expects the rupee to depreciate by 4.6% against the US dollar in 2020 despite a stable run in the first half of the year. Sri Lanka’s total debt repayment for 2020 is Rs2.4 trillion. Debt to GDP is expected to increase to 85% in 2019 but dip marginally to 84% in 2020 due to higher GDP growth, lower debt repayments and foreign direct investments mainly into the Colombo Port City. While overall bond repayments will dip in 2020, foreign debt repayments remain high in the second and third quarters.
“The Year 2020 illustrates a notable reduction in repayments especially in the first and fourth quarters, however, we expect foreign payments in the range of $300-350 million to exist monthly in the form of project loan repayments with relatively high repayments in the second and third quarters,” First Capital notes. The policy rate cut on top of the fiscal stimulus prompted foreign selling of government securities which impacted market liquidity. However, due to restrictive foreign holdings, the market impact was low. Private sector credit improving to 14% in 2020 will further tighten liquidity. Sovereign rating risk is another concern. The government’s fiscal stimulus has been criticized by sovereign rating agencies. Fitch downgraded the outlook on Sri Lanka to ‘Negative’ indicating a possible rating downgrade in the future.
This will likely make capital raising in international markets more expensive. The rating downgrade risk is offset by the South Asian region’s economic growth prospects. With the US Fed expected to hold rates, foreign investors could find the region’s bond markets attractive, particularly in Sri Lanka with improved political stability and growth. However, ensuring fiscal discipline will be critical to ensure the tax cuts and monetary easing have their desired effect on the economy.