Bangladesh and Sri Lanka Deliver Dovish Surprises

chinaThe central banks of Bangladesh and Sri Lanka surprised markets with rate cuts today.  Both moves were in response to falling inflation and sluggish growth.  While both currencies are heavily managed, the moves are a bit risky as broader EM FX comes under greater pressure.  Of the two, we view LKR as being more vulnerable.

BANGLADESH ECONOMIC OUTLOOK

The economy is slowing.  GDP growth is forecast by the World Bank at 6.4% in FY2018, down from 7.1% in FY2017 and 7.2% in FY2016.  With several indicators suggesting that a regional slowdown is under way in Q1, we see some downside risks to the growth forecasts.  This is also underscored by rising tensions that could impact global trade flows.

Price pressures are slowly falling, with CPI inflation at 5.68% y/y in March.  This is down from the 6.1% peak in September.  The central bank has an inflation target of 6% for FY2018, and so falling price pressures support the case for easing monetary policy.

Bangladesh Bank cut the repo rate 75 bp to 6.0%.  The bank last eased in January 2016 with a 50 bp cut to 6.75%.  Before that, the last move was a 50 bp cut to 7.25% in February 2013.  Clearly, the central bank moves very cautiously and so we suspect easing this year will likewise by done quite slowly.

The external accounts are worsening modestly.  According to the World Bank, the current account surplus was equal to 0.6% of GDP in FY2016.  It moved into modest deficit in FY2017, equal to -0.7% of GDP.  Market consensus sees some further widening to -1% of GDP in FY2018.  Note that Bangladesh’s largest export markets are the US, Germany, and the UK.

Foreign reserves are making new record highs to $33 bln in February.  This is equivalent to over 8 months of imports, and represents nearly 4 times the stock of external short-term debt.  As such, we believe external vulnerabilities are fairly low.

SRI LANKA ECONOMIC OUTLOOK

The economy remains sluggish.  The central bank noted that GDP growth was “subpar” at 3.1% in 2017, down from 4.5% in 2016.  Growth is forecast by the IMF to pick up to 4.6% in 2018 and 5.1% in 2019.  For the same reasons as we cited for Bangladesh, we see downside risks to the growth forecasts here as well.

Price pressures are falling, with CPI inflation at 4.2% y/y in March.  This is the lowest rate since November 2016, and near the bottom of the 4-6% target range, and so falling price pressures support the case for easing monetary policy.

Central Bank of Sri Lanka cut the top of its interest rate corridor by 25 bp to 8.5% while leaving the bottom unchanged at 7.25%.  The last move was a 25 bp hike in both rates back in March 2017.  During that tightening cycle, the central bank tightened by a cumulative 125 bp and so we expect modest easing to continue this year.  The bank noted that “The narrower policy rate corridor will also help the Central Bank to maintain short term interest rates at desirable levels with less volatility.”

The external accounts are expected to improve.  The current account deficit was an estimated -3.0% of GDP in 2017.  The IMF expects the deficit to narrow to -2.5% of GDP in 2018.  Note that Bangladesh’s largest export markets are the US, the UK, and India.

Foreign reserves have recovered in recent months to $6.7 bln in January.  This is equivalent to 3 months of imports, and represents less than 90% of the stock of external short-term debt.  The December 2017 reading of $7 bln was the highest since December 2014.  However, the metrics suggest external vulnerabilities are still fairly high. 

INVESTMENT OUTLOOK

Both the Sri Lankan rupee and the Bangladesh take are tightly controlled currencies.  We believe looser monetary policy will lead both to weaken modestly this year, with greater risks for LKR given the fundamental backdrop.  USD/BDT could rise above 85 while USD/LKR could rise above 160.

Let’s look at their recent performance.  LKR is -1.5% YTD whilst BDT is -1% YTD.  This compares to the best EM performers MXN (+8% YTD) and COP (+7%) as well as the worst performers ARS (-8%) and TRY (-5%).  Last year, LKR was -2.5% YTD whilst BDT was -4.5%.  This compares to the best EM performers KRW (+13%) and MYR (+11%) as well as the worst performers ARS (-14.5%) and TRY (-7%).

Bangladesh equities are underperforming whilst Sri Lankan are outperforming.  So far this year, MSCI Bangladesh is -0.3% YTD while MSCI Sri Lanka is +5.7%.  This compares to +3.4% YTD for MSCI Frontier and flat YTD for MSCI EM.  For comparison’s sake, note that in 2017, MSCI Bangladesh was +22.5% while MSCI Sri Lanka was +1%.  This compares to +28.5 for MSCI Frontier and +34% for MSCI EM.

With similar inflation and monetary policy dynamics, we believe local currency governments in both countries will likely outperform in 2018.  Bangladesh’s implied rating was steady at BBB/Baa2/BBB after rising a notch last quarter.  We see strong upgrade potential to actual ratings of BB-/Ba3/BB-.  Sri Lanka saw its implied rating steady at BB-/Ba3/BB- after rising a notch last quarter.  Upgrade potential remains in play for actual ratings of B+/B1/B+.