LNP – Weaker reserves, debt repayments hinder SL’s ability to cut rates further: Moody’s

• Says SL’s foreign reserves position set to weaken with settling of US $ 1bn scheduled for next month
• Points out it could add depreciation pressure on rupee, which “will constrain Central Bank’s monetary policy flexibility”
• Says weaker dollar inflows from subdued tourism and textile receipts likely to keep reserves low through remainder of 2020
• Moody’s in April placed SL on B2 rating on review for potential downgrade 

Moody’s Investors Service has flagged concerns about possible constrains to Sri Lanka’s ability to have continued flexibility in its monetary policy, as the country is set to settle a billion dollar bond next month, using its external reserves, which could spark greater depreciation pressure on the rupee, raising the cost of imports as a consequence. 

The Monetary Board has been extremely dovish so far this year, which was made possible due to the modest prices, muted demand, subdued imports and negative private sector credit. This gave more wiggle room for the policy rate setting committee to cut key rates by 250 basis points, in four instances and release billions of liquidity into credit markets. 

The coronavirus also necessitated the central banks around the world to provide unrestrained monetary stimulus by way of liquidity, to soften the economic impact of the pandemic. 
Sri Lanka’s official foreign reserves rose consecutively for two months to US $ 7.4 billion by end-August, sufficient to cover 4.7 months of imports. But Moody’s said the next month’s scheduled repayment of a sovereign bond of a billion dollars could weaken the reserves, adding depreciation pressure on the rupee, which “will constrain the Central Bank’s monetary policy flexibility”. 

“It could also spark greater local currency depreciation, raising the cost of imports and increasing governments’ fiscal risks, given high levels of foreign currency debt. Such credit pressures are likely to be largest for Sri Lanka,” Moody’s said in a report, which assessed the liquidity strains on lower rated sovereigns exacerbated by the pandemic.

However, there is a broader consensus that the Central Bank will remain ‘lower-for-longer’, to support businesses and the economy damaged by the pandemic. 

In April, Moody’s placed Sri Lanka’s B2 rating on review for potential downgrade, citing that the pandemic elevated the country’s already heightened debt refinancing risks and the bloated fiscal deficit. 

Dollar outflows resulting from foreign currency debt repayments out of external reserves could weigh on the rupee in the short term, making the imports expensive, until the country recoup such funds through other inflows generated via exports, loans and investments. 

Sri Lanka has made decent strides in the areas of merchandise exports and raised funds via alternative financing sources such as bilateral borrowings and swap lines in the pandemic’s aftermath.  

The country raised US $ 1.2 billion from China Development Bank while it entered into a US $ 400 million swap line with the Reserve Bank of India, bolstering its reserves.
However, Moody’s is of the view that the “weaker dollar inflows from subdued tourism and textile receipts are likely to keep reserves low through the remainder of 2020”.   

Robust recover in export earnings and the subdued imports have made possible for the country to largely offset the loss of earnings from the tourism trade and other current account inflows. This has enabled the Central Bank to still remain a net buyer of foreign exchange in the market, accumulating assets to the reserves.