Moody’s advocates rate hike to limit capital flight

Ratings agency Moody’s yesterday noted that Sri Lanka’s Central Bank may have to tighten its monetary policy to limit capital outflows, in the midst of the country’s reserves falling significantly over the past two months. 
“Sri Lanka’s relatively low level of foreign exchange reserves further complicates the monetary policy, as the Central Bank may need to hike rates faster than desired in order to limit capital outflows or attract portfolio inflows in an environment where the US interest rates are rising and global investors are generally retreating from emerging markets,” Moody’s said in a report.
Sri Lanka’s foreign exchange reserves have continued their downward spiral through November as the country’s value of foreign exchange reserves—excluding gold and Special Drawing Rights—has fallen by 6.7 percent or US $ 340 million to US $ 4.73 billion.  This is in comparison to a reserves balance of US $ 5.07 billion in October and a more recent peak of US $ 5.59 billion reached in August 2016.
The situation arises at a time when the International Monetary Fund (IMF) also expressed its concerns over the depleting foreign reserves of the country in response to the recent volatility in the global financial markets, as market participants expected a rise in US Treasury yields. 
As expected, the US Federal Reserve last week raised its benchmark interest rates by 25 basis points for the first time in a year and second time in a decade, which saw over US $ 17 billion worth of investments transferring into safer US Treasuries from emerging markets.
The Sri Lankan government securities market also witnessed over Rs.50 billion in foreign outflows since October, putting pressure on the rupee and 
interest rates. 

The IMF also advocated the authorities recently to stand ready to tighten rates further if the private sector credit growth did not show any sign of abating. 
However, higher rates could cripple the economic growth as higher borrowing costs will dampen investments and consumption while raising the government’s borrowing cost, adding more fiscal pressure.  
In this light, Moody’s questioned how practical it would be to unwind the existing swaps and exclude them from taking into account in meeting the net international reserves as such action could further deplete the reserves. 
As part of the three-year, US $ 1.5 billion IMF deal, the Central Bank has been asked to slash its outstanding swaps portfolio and the dollars acquired through such derivatives will also not be counted as part of foreign exchange reserves for meeting the deal’s eligibility targets. 
“At this stage, it is not clear how this will be achieved in an environment of fragile capital inflows that may drain rather than inflate foreign exchange reserves,” Moody’s opined. 
Meanwhile, the depleting reserves have also escalated Sri Lanka’s external debt vulnerability as there are sizeable amounts of foreign debt repayments, particularly from 2019 to 2022. 
According to Moody’s, US $ 14 billion in foreign debt service payments would be due during this period. This is besides US $ 2.2 billion and US $ 2.4 billion worth of foreign debt servicing that is due in 2017 and 2018, respectively. 
Therefore, Moody’s expects Sri Lanka’s external vulnerability indicator (EVI), which measures the ratio of external debt payments due over the next year to foreign exchange reserves, to remain elevated at around 140 percent at year-end 2016. 
“We expect the EVI to rise to about 155 percent in 2017, before slowly declining thereafter,” Moody’s said.  
Further, Sri Lanka also remains an outlier among the similar rates peer countries with the weakest debt affordability as Moody’s believes the persistent fiscal deficits could further raise debt levels. 
Debt affordability is measured through the general government interest payments as a share of revenues and 35 percent of state revenues in 2015 had been spent on these interest payments in Sri Lanka, which is the highest among the peers, Moody’s noted. 
“With nominal GDP growth likely to be slower in coming years than over the past decade, persistent and sizeable deficits will raise debt levels further,” Moody’s said. 
In June this year, Moody’s affirmed Sri Lanka’s foreign currency issuer and senior unsecured sovereign ratings at B1 and changed the outlook to negative from stable.