Boston, MA -- (SBWIRE) -- 04/30/2013 -- Core Views

We have long cautioned that the political unassailability of the ruling United People's Freedom Alliance greatly increases the risk of government overreach. Recent developments, such as the impeachment of the country's chief justice, have only bolstered our view.

More than two and a half years after the EU decided to withdraw preferential tariff benefits to Sri Lanka, it appears that the country's exporters are now beginning to feel the economic squeeze. The ruling government's inadequate progress on the human rights front suggests to us that these privileges are unlikely to be reinstated any time soon.

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We do not see the island's economic growth turning up until H213 at the very earliest, implying that the ongoing slowdown will likely intensify in H113. We are keeping to our 5.4% full-year real GDP growth forecast for 2013. The island's economy is still feeling the pinch on multiple fronts, namely high credit costs, the weak Sri Lankan rupee, and the fragile state of developed markets.

With price concerns gradually diminishing, we believe that the primary focus of the Central Bank of Sri Lanka (CBSL)'s policies over the coming 12 months will be economic growth. We are projecting 100 basis points of additional easing in 2013, taking the reverse repo rate to 8.50% by end-2013. Crucially, the CBSL's annual road map signals further loosening of monetary policy in the months ahead.

Currency stability is likely to be the overriding theme for the central bank following a fairly volatile 2012. The CBSL explicitly expressed exchange rate stability as one of its policy priorities in its annual road map for the year ahead, reiterating its willingness to intervene.

The government aims to narrow the fiscal deficit to 5.8% of GDP by end-2013. We believe there will be nothing revolutionary about how the government conducts its business this year, and that the amount of fiscal consolidation will very likely be minimal at best.

While the country's overall business environment remains mediocre from a pan-Asian perspective, we cannot ignore the rapid and dynamic changes taking place in its regulatory framework, which indicate that its business environment is making significant strides. This is likely to help to sustain the country's foreign direct investment boom.

Major Forecast Changes

We have toned down our expectations for further rupee strength and have set a conservative target of LKR126.00/US$ by end 2013, with the unit expected to average at LKR126.85/US$ for the year.

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