‘Rupee Volatility – In Search of Equilibrium’

Following is an Economic Update compiled by Talaal Maruzook and Sanjeewa Fernando of CT SMITH Stockbrokers (Pvt) Ltd. titled ‘Rupee Volatility – In Search of Equilibrium’
On 10 February 2012, the Central Bank of Sri Lanka (CBSL) stated that it would limit its intervention in the Sri Lankan Rupee (SLR), resulting in a sharp, and possibly excessive, correction in the value of the SLR.

A correction six months in the making
Amidst the rising trade deficit in 2H2011, the CBSL was advised by the International Monetary Fund (IMF) to reduce intervention in the currency and allow for more flexibility, thereby avoiding undue currency shocks.
At the time, the CBSL was maintaining control over both the interest rate (which was near historic lows) and exchange rate, which was kept stable at Rs. 110 per US$ through State-bank intervention.

The CBSL was of the view that service and capital inflows will offset the trade account impact (the deficit was US$ 5,585 m in 2H2011, up 146% YoY), and continued to defend the currency, drawing down foreign reserves.
The environment however started to change in November 2011, when the Government unexpectedly devalued the SLR by 3% overnight in its Budget for 2012. The currency subsequently adjusted at the new floor of Rs. 113.75, with the CBSL intervening in the market. However, with foreign reserves continuing to erode, and the IMF stating that it would temporarily halt disbursement of its loan tranches (in Sept 2011), it appeared that further currency depreciation was required.
When the CBSL revised its exchange rate policy in February 2012, the move was unexpected as previous policy direction had not indicated a change in the CBSL’s exchange rate stance. The consequent correction in the SLR sparked one of its largest declines vs. the US$ (down 13.4% since 09 February 2012) making the SLR the worst performing currency in Asia.
Although the SLR was always expected to depreciate subsequent to reduced CBSL intervention, the extent of the fall has come as a surprise to many. Of particular concern has been the currency performance in the past week, where the SLR has fallen 7.4%.
Forex market participants have attributed recent volatility to the following factors:

• Seasonally high import demand ahead of the Sinhala & Tamil New Year in April
• Exporters delaying US$ conversions in expectation of a further decline in the SLR
• The CBSL limiting net open positions of commercial banks
• Informal speculation on the currency

Our expectations
So does the current SLR really reflect the value of the currency? Based on our in-house estimates, we believe the currency has overshot its equilibrium, and expect the SLR to settle at between Rs.120-125 per US$ by end-2012E. Therefore, the currency is expected to decline 6-11% in 2012E, i.e. recovering 2-7% from present levels.
Overall, we estimate the Balance of Payment deficit to reach approximately US$0.5-0.7 b in 2012E, although we have not factored in a potential increase in the oil import bill if Sri Lanka is compelled to repay the Iran credit facility.
There are a few key factors we believe are prerequisite for a revival in the SLR, which are as follows:
1) Further monetary tightening resulting in interest rates continuing to trend upward
We believe that further monetary policy tightening is required, and expect T-bill yields to rise a further 200-250bps by end-2012E (the 12-month T-bill yield presently stands at 11.1%). The CBSL increased its policy rates by 50bps in February 2012 (first increase in close upon five years) prior to relaxing its exchange rate policy, and we believe a further policy rate hike is required in the near term.
Treasury bill yields had nonetheless been moving upward since September 2011, and the 12-month T-bill yield has risen 386bps since end-August 2011 (and 181bps since the policy rate hike)
2) Disbursement from the IMF with regard to the stand-by loan facility
Sri Lanka is yet to receive two tranches of its US$ 2.6 b standby loan from the IMF, amounting to approximately US$ 800 m. However, the IMF has looked positively on the recent moves by the Government, and some reports suggest it may make a disbursal in April 2012
3) Timing of external inflows to Sri Lanka, in the form of debt, equity and FDIs
Considerable non-trade foreign inflows are expected in 2012E, in the form of FDIs, capital market investments and debt inflows. The CBSL yesterday issued a press release stating that there had been a significant foreign currency inflows to Sri Lanka in recent weeks, totalling US$ 760 m, and it expects the SLR to stabilise in the coming weeks.
Sources included the Colombo Stock Exchange (US$ 164 m in 2012YTD on account of large transactions in major blue-chips), investments in commercial banks (US$ 127 m), Sri Lanka Development Bonds (US$ 84 m) and net foreign investments in Treasury Bills and Bonds (US$ 385 m in 2012YTD). Further inflows are expected in the next few weeks on account of Tier II capital raising by commercial banks, and an initial investment of US$ 73 m in a hotel project.
4) The impact of the credit containment measures implemented by the CBSL
In its Monetary Policy Review for February 2012, the CBSL directed commercial banks to limit their credit disbursements to 18-23%, thereby limiting credit growth, which we expect at 23% for 2012E (vs. 32% in 2011). We thus expect there to be a consequent reduction in import credit.
5) Clear and consistent policy direction from the CBSL
Given the events in the recent past, a clear and consistent policy direction will assist in assuring forex and money market participants as to the stability of the domestic financial system, thereby partially mitigating potential speculation and volatility in the market.
Although we expect there to be upside to the SLR by the year-end, there remains near term downside risk as speculation and volatility may yet continue to temporarily weigh down on the currency.
Of particular concern is Sri Lanka’s oil import bill, and its impact on the trade deficit, especially subsequent to US sanctions on Iran w.e.f. 01 July 2012. Sri Lanka presently enjoys a four-month trade credit facility with Iran, and imports approximately 90% of its crude oil from the country.
While it is unknown what impact the sanctions will have on the trade credit provided to Sri Lanka, the country is presently exploring alternative methods of dealing with Iran for oil procurements (potentially at higher transaction costs), failing which Sri Lanka will have to seek alternative sources for crude oil. The oil import bill in 2011 was US$ 4.6 b (22.9% of total imports).