Currency Forecast - LKR: Further Weakness Ahead But A Crisis Is Unlikely - APR 2017

BMI View: We believe that the LKR will continue to depreciate mainly due to elevated inflationary pressures. Nevertheless, we expect the currency to avert a crisis, and instead weaken at a gradual pace over the coming quarters. The inflation outlook will improve slowly in line with the government's progress with fiscal consolidation, while dollar inflows from Chinese investments will add support to the currency. We forecast the rupee to average LKR154.00/USD in 2017 and LKR158.56/USD in 2018.

Short Term Outlook (three-to-six Months)

We expect further rupee weakness over the coming months primarily because inflationary pressures remain elevated. Credit growth continues to exceed 20% in y-o-y terms, and food prices are likely to trend higher in Q117 due to a severe drought. We therefore believe that headline inflation is likely to rise further, after increasing to 5.5% y-o-y in January from 4.5% y-o-y in December (based on the Colombo CPI). At the same time, the central bank will likely refrain from tightening its monetary policy due to ongoing headwinds to growth, partly due to the drought and an uncertain outlook for export demand. This implies that real interest rates will decline, thus increasing downward pressures on the currency. We also highlight that the central bank will likely allow the rupee to slide further in the near term, as it will refrain from dipping into its shrinking holdings of foreign currency reserves to defend the currency. Indeed, the central bank stated in its Road Map for 2017 that exchange rate flexibility and export competitiveness are crucial goals for the economy, adding that its previous efforts to maintain an overvalued rupee through the use of reserves were not sustainable.

Rupee To Slide Further
Sri Lanka - Exchange Rate, LKR/USD
Source: Bloomberg, BMI

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