Shiran Fernando evaluates our vulnerability to world markets

In recent years, with the economy entering into the classification of being a middle-income per capita nation, Sri Lanka has moved away from its tag of being a ‘donor darling.’ With this shift, there’s also been another noticeable change: an increased reliance on international capital markets for commercial debt.

Back in 2009, Sri Lanka’s foreign debt consisted of 72 percent concessional debt and 28 percent commercial debt. But in 2015, this composition stood at a near-even keel – at 49 and 51 percent respectively.

Sri Lanka has been reliant on inflows to the local Treasury Bill and bond markets following this movement. This reliance in part is to do with inadequate levels of foreign direct investment (FDI).

The country has benefitted from a period of low global interest rates with capital moving towards high-yielding instruments such as Sri Lankan Rupee bonds in a relative yield context.

MARKET SENSITIVITY When uncertainty or surprises jolt global markets, there is a tendency for investor sentiment to turn negative. This is generally referred to as ‘risk-off sentiment’ in which global investors move away from investing in risk asset classes like emerging and frontier markets (e.g. Sri Lanka), into safe-haven assets such as gold and US Treasuries.

During this period of uncertainty and volatility, we have seen an impact on Sri Lanka’s local government securities market on several occasions. This has been by way of a decline in the foreign holdings of these securities.

MAIN HIGHLIGHTS Last year, there were net outflows (i.e. with inflows minus outflows being negative) in foreign holdings of Rs. 44 billion. If we were to break down this figure on a quarterly basis, the impact from external factors would become clearer.

In the January-March quarter of 2016, there was a net outflow of 83 billion rupees. This was driven by jitters in the global markets following developments in a rebalancing Chinese economy. Once this worry settled down, inflows returned to markets like Sri Lanka in the subsequent two quarters – the second and third quarters saw net inflows of 32 and 62 billion rupees respectively.

KEY CONTRIBUTORS There were a couple of key factors that led to an inflow of Rs. 62 billion in the third quarter of 2016. Not only were emerging markets viewed positively following the Brexit vote but there was improved confidence in Sri Lanka’s economic outlook.

This followed  the approval of the IMF Extended Fund Facility programme and appointment of Dr. Indrajit Coomaraswamy as Governor of the Central Bank of Sri Lanka. Similarly, in this quarter, the Government of Sri Lanka was able to issue US$ 1.5 billion in sovereign dollar bonds that temporarily eased borrowing concerns.

However, in the fourth quarter, the momentum of inflows failed to continue. This was very much due to concerns over a potential rate hike in December by the US Federal Reserve (which materialised) and its impact on emerging markets.

THE RUPEE IMPACT While outflows have an impact on domestic interest rates, there is a negative impact on the currency when foreigners withdraw their investments. In 2015, much of the rupee depreciation against the US Dollar was attributed to the pressure in servicing foreign debt.

Moreover, there was a net outflow or decline of Rs. 153 billion from the local bills and bonds market that can also be classified as a contributory factor for the currency’s weakness.

Last year, a net decline in foreign holdings of Rs. 44 billion added pressure on the local currency. This was particularly the case in the fourth quarter when the rupee weakened by around 2.5 percent against the dollar amid the outflows noted above. In the third quarter, with net inflows to the market, there was less pressure on the currency and it in fact strengthened somewhat during that brief period.

The other impact of foreign outflows is the erosion of Sri Lanka’s gross official reserves. Following the successful bond issue in July 2016 and portfolio inflows, reserves rose to US$ 6.6 billion by end-August. But by the end of November, reserves slumped to US$ 5.6 billion due to the net outflows in the last quarter.

FUTURE EXPECTATIONS With the decline in foreign holdings of government securities over the last two years, Sri Lanka is less exposed to swings in global markets compared to its position in the past. By the end of last year, these holdings amounted to Rs. 260 billion in comparison to 476 billion rupees at the end of 2013.

However, the sharp swings in inflows and outflows remain unpredictable, and will continue to keep variables such as the currency and reserves sensitive in an environment where global markets remain uncertain.