Sri Lanka Country Risk Report Q4 2018
Sri Lanka's real GDP growth came in at 3.2% y-o-y for Q118, similar to the previous quarter, as the secondary sector underperformed. However, we expect growth to be broad-based and to pick up over the rest of the year, helped by low base effects and government policies. Accordingly, we maintain our forecast for real GDP growth to pick up to 4.2% in 2018, from 3.1% in 2017.
The CBSL left its benchmark Standing Lending Facility Rate and Standing Deposit Facility Rate on hold at 8.50% and 7.25%, respectively, at its monetary policy review meeting on August 3. We believe that the recent uptick in inflation is likely to be transitory and we continue to expect easing food supply conditions over the coming months to offset upside price pressures from elevated global oil prices and still-rapid money supply growth. As such, we are maintaining our forecast for the CBSL to hold its policy rates through end-2018.
We expect to see a shift towards populist measures in the lead up to the 2020 parliamentary elections as the incumbent government seeks to shore up support for the ruling coalition parties, following their defeat at the local authority elections. While these measures should boost citizen welfare, the increase in govern-ment spending, without adequate revenue mobilisation reforms to match, could pose downside risks to the fiscal outlook.
We are revising our view for the Sri Lankan rupee to weaken further against the US dollar, with our average forecast standing at LKR158.50/USD in 2018 and LKR164.00/USD in 2019. Over the short term, this will likely be driven by narrowing interest rate differentials, deteriorating terms of trade and the CBSL's dovish monetary policy stance. Over the longer term, higher inflation in Sri Lanka vis-à-vis the US and the need for continued foreign reserve accumulation will likely weigh on the rupee.
Political tensions within the coalition government could undermine progress with political and economic reforms, thus weighing on investor sentiment. This could limit FDI inflows, posing downside risks to our growth forecast. At the same time, Sri Lanka's external finances remain weak, and external debt payments maturing from 2018 onwards will likely strain the country's foreign reserve holdings. Additionally, prolonged external headwinds could exert more downside pressure on the currency, leading to a stronger depreciation relative to our forecasts for the rupee to continue to weaken gradually over the coming quarters.
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