The Sri Lankan Rupee (LKR) was the best performing emerging market currency for the first eight months of 2024, taking the top spot for five consecutive months since March, according to Bloomberg market data.

By the second week of October, the rupee had appreciated by over 10% in 2024, a feat which many thought unlikely after the Presidential Election.

The rupee appreciated by 10.8% Year-on-Year (YoY) in 2023 after sharply depreciating 81.2% in the crisis year of 2022, when the Central Bank of Sri Lanka (CBSL) floated the rupee after holding on to it for almost a year.

Due to the recovery of tourism receipts and remittances and increased inflows from development partners, useable official reserves increased to $ 3 billion by end-2023 (equivalent to 2.1 months of imports), compared to $ 500 million at end-2022. 

Sri Lanka’s gross official reserves rose by $ 38 million to $ 5,992 million in September from a month earlier as the CBSL had net purchases of $ 96 million to manage its soft peg.

The CBSL has been broadly operating a deflationary policy since around September 2022, killing liquidity from dollar purchases by selling its domestic assets to the banking system (or getting coupon interest on bonds), triggering Balance of Payments (BOP) surpluses.

Gross official reserves consist of the CBSL’s monetary reserves (collected with deflationary policy or through sterilising dollar purchases) and fiscal reserves of the Treasury built temporarily with foreign borrowings.

Sri Lanka has built reserves with deflationary policy and has repaid debt on a net basis.

The CBSL is also repaying its borrowings from the International Monetary Fund (IMF) as well as from the Reserve Bank of India.

Data also showed that net foreign assets of the CBSL continued to improve up to August.

Investor confidence in AKD Govt. pushing rupee up 

Last week, Bloomberg Intelligence, the research arm of Bloomberg News, said that the non-radical approach of President Anura Kumara Dissanayake was pushing up the rupee due to improving investor sentiment.

It said that the rupee, which was volatile and had fallen in the run-up to the Presidential Election on 21 September, had been appreciating since then.

“Our foreign exchange decomposition model suggests improving investor sentiment is pushing up the currency, the main reason – new President Dissanayake’s recent steps suggest that he’s not as radical as the market was thinking,” Bloomberg Intelligence said.

According to the report, the cumulative contributions of four factors have moved the rupee up since 1 September – domestic sentiment, growth, monetary policy, and US growth.

“The rupee has strengthened by around 2% against the dollar since early September,” the report said.

CBSL expects vehicle imports to exert pressure on LKR

Further, the CBSL Financial Stability Review noted that the anticipated gradual pick-up of import demand due to economic recovery amidst the relaxed monetary policy stance and the relaxation of restrictions on vehicle imports would exert pressure on the rupee unless this outflow requirement was compensated by increased inflows, especially by long-term-oriented Foreign Direct Investments (FDIs).

Furthermore, it said that should the geopolitical tensions, particularly in the Middle East, escalate, it would affect inflow of worker remittances as well as expenditure on fuel and trade.

It also said that Sri Lankan banks had maintained $ 3.7 billion with financial institutions abroad by the end of Q2 2024, which had enabled them to meet foreign currency requirements despite shortages in the domestic market.

The CBSL said that the banking sector had maintained a considerable amount of foreign currency funds with financial institutions abroad for prudential liquidity risk management.

It noted that the banking sector had significantly improved its balances with financial institutions abroad from 2021 to meet their liquidity needs in foreign currency, in an environment where a foreign exchange liquidity deficit was prevailing in the domestic forex market.

“This enabled banks to maintain their ability to meet Foreign Currency (FCY) obligations and facilitate the importation of necessities,” the report said.

Therefore, at the end of Q2 2024, the banking sector maintained a balance of $ 3.7 billion with financial institutions abroad and a growth of 8.7% YoY.

However, the CBSL said that the higher accumulation of funds abroad may reduce the profitability of the banking sector due to tying up of funds that might otherwise be used for more profitable investments.

Nevertheless, it was observed that such balances had declined over the past three quarters, mainly due to the decline in balances of domestic banks which are not Domestic Systemically Important Banks (D-SIBs) and foreign banks.

D-SIBs maintained the highest amount of balances with financial institutions abroad of $ 1.6 billion, while foreign banks also possessed a significant amount of balances amounting to $ 1.5 billion at the end of Q2 2024.

LKR will stay between Rs. 295-300 per USD by end-2024

Speaking to The Sunday Morning, First Capital Chief Research and Strategy Officer Dimantha Mathew said that they forecast the rupee to remain in the range of Rs. 295-305 per US Dollar until December.

He said that consumer demand had not really accelerated in line with expectations, which had led to the appreciation of the rupee. Additionally, Sri Lanka is currently undergoing the peak season of exports and tourism, which has also supported the appreciation.

CBSL data showed that earnings from industrial exports had increased by 6.1% to $ 6,658.6 million and agricultural exports had increased by 5.9% to $ 1,804 million, while mineral export earnings had increased by 19.8% to $ 18.8 million in the first eight months of 2024. 

Increased export earnings from textile and garments, tea, petroleum products, and rubber products has mainly contributed to this growth.

Meanwhile, import expenditure on consumer, intermediate, and investment goods had increased by 7.3% to $ 2,176.3 million, by 7.9% to $7,750 million, and by 22.5% to $ 2,140.3 million, respectively, in the first eight months of 2024. 

The total import expenditure grew mainly due to the increase in import expenditure on refined petroleum, textiles and textile articles, machinery and equipment, and food and beverages with the revival of economic activities and removal of import restrictions, as well as due to the impact of high commodity prices in the global markets.

Mathew said that in addition to these inflows, the peak season of worker remittances would also take place between December and March 2025, which would lead to further appreciation amid a lack of debt repayment.

He said more dollars were converted to rupees than vice versa, which had led to the rupee appreciation. However, he noted that given the lack of demand, there was still room to increase consumer demand in the market.

“The Government should impose taxes to prevent the rupee from falling excessively with the lifting of the vehicle import ban as it did before,” Mathew said, adding that it should impose taxes on imports to limit vehicle imports while increasing Government revenue.

He said that monthly vehicle imports up to $ 200 million could be managed by the domestic foreign exchange market without causing volatility in the exchange rate. Further, he said that there was an auto-correction situation, where the rupee automatically depreciated when there was excessive demand, given that it was currently at market price.

“The impact of policy uncertainty on the rupee is gradually easing off,” he said, adding that this was the reason the rupee had depreciated in the run-up to the Presidential Election.

Debt repayment requires higher foreign exchange, pressuring rupee

Speaking to The Sunday Morning, Frontier Research Senior Macroeconomist Thilina Panduwawala said that there should be an immediate payment as indicated by the agreement in principle with the bondholders, which was around $ 500 million, including the consent fee. 

Sri Lanka will be liable to pay a consent fee of $ 225 million upfront and capital repayment on the past due interest bond of $ 117 million in 2024, depending on the date of the signing of the agreement with bondholders.

“It should not have any direct impact on the currency as the Treasury has a foreign exchange balance that is being maintained, which is sufficient to pay off the payment,” Panduwawala said. 

He said that the only impact would be on the reserves as it would take out about $ 500 million, unless the net purchases by the CBSL were as high as around $ 500 million in that particular month. He added that such payment may have a sentiment impact which could cause some volatility in the currency. 

On debt repayment, Panduwawala said that although there existed a five-year debt moratorium, it was only applicable for the original principal payments of the sovereign bonds and the bilateral debt. 

He noted that Sri Lanka would still have to pay the past due interest and the new interest on the International Sovereign Bonds (ISBs) until 2027.

He said that due to these payments, there would definitely be a higher foreign exchange requirement from the reserves, as the CBSL would sometimes be forced to make additional purchases from the market in order to maintain the reserves, unless there was foreign financing, since the IMF programme required reserves to be at $ 13.4 billion by 2027.

A few years for consumer demand to normalise 

Speaking to The Sunday Morning on condition of anonymity, a market analyst from a leading investment firm in Colombo said that consumer demand had started to pick up compared to the crisis period over the last two years. However, they noted that it could not be expected to return to 2021 levels immediately – a period which saw money printing and lower taxes.

“Getting back to that level will entail a long-term journey,” the analyst said.

Further, they noted that for most employees, disposable income had not seen a sharp increase but a gradual rise. 

According to him, only bigger companies have undertaken the salary adjustments speedily, while in the public sector, which has a considerable workforce, the adjustments have been quite small. He noted that it would take a few years for the real wage to get adjusted.

CBSL data showed that the Real Wage Rate Index of the public sector stood at 69.4 by the end of July while the Nominal Wage Rate Index stood at 161.3.

The informal private sector Real Wage Rate Index stood at 85.5 by the end of July and the Nominal Wage Rate Index was at 180.8.

Tourist numbers will drive consumer demand 

“We are also looking at tourism numbers hitting close to 2019 numbers, probably towards the end of this year,” the analyst said, adding that these numbers may reach 2018 levels or beyond by the end of 2025 should the newly opened City of Dreams project fall into place.

Sri Lanka’s tourism sector peaked in 2018 with 2.4 million visitors and $ 4.4 billion in revenue, while in 2019 the numbers fell to 1.9 million and $ 3.6 billion due to the Easter Sunday attacks.

The analyst said that if the City of Dreams and the casinos managed to attract tourists, it would lead to the improvement of the livelihoods of those involved in tourism, as there would be a knock-on effect with tourists visiting other parts of the country.

John Keells Holdings PLC opened the doors of its flagship integrated development ‘Cinnamon Life at City of Dreams’ on 15 October. 

The soft opening, branded under Cinnamon Life, included the opening of a 687-room hotel, a range of ballrooms, banquet facilities with an exhibition centre, and world-class restaurants.

The mall, along with the casino and ultra luxury 113-room Nuwa hotel, managed by Melco Resorts and Entertainment Ltd. (Melco), is set to follow in the next phase in mid-2025.

Moreover, the analyst pointed out that although inflation had been negative 0.5% in September, this was only when compared to where the prices had stood in September 2023.

“The prices which increased during the crisis have not come down. This increase in prices is not fully reversible since the currency was at Rs. 203 per US Dollar at that time, while it is now at about Rs. 300 per US Dollar,” he explained. 

He said that the prices and disposable income had a twofold impact, as inflation increased the cost of living while taxes, which had more than doubled for some people, eroded disposable income.

New vehicles will have limited demand initially

The market analyst expects the exchange rate to remain between Rs. 290-300 per US Dollar by the end of 2024 and for it to increase beyond that range next year.

He said that the commencement of external debt servicing and vehicle imports could exert some pressure on the rupee. “There will be some level of pressure on the rupee with the lifting of the vehicle import ban and the servicing of external debt, both of which will start more or less at the same time,” he added.

He noted that the base price of vehicles when imported would be relatively higher, which would limit the demand for brand new vehicles at the beginning.