Foreign investments in government bonds halve

The Central Bank’s delay in increasing key interest rates botches recovery

Foreign investments in government securities declined 57% in two years to Rs197 billion by March 2017, reversing a recovery in the previous year because the Central Bank delayed increasing monetary policy rates.

foreign Tbond holdings

The Central Bank raised policy interest rates by 25 basis points in March 2017, to contain the outflow and inflation, which accelerated to 8.2% in February. “Higher interest rates would take away incentives for foreign bondholders to sell,” Central Bank Governor Indrajit Coomaraswamy told a press conference announcing the March monetary policy change that’s come a little too late.

Since September 2016, the International Monetary Fund has requested Sri Lanka to increase interest rates, and suspended a December review after foreign reserve targets were missed. The fund has delayed disbursing the second tranche under the $1.5 billion Extended Fund Facility programme.

“The bank should’ve raised interest rates much earlier,” says Sanjeewa Fernando, executive director of research at CT CLSA Securities, a stockbroking firm. “We could have reduced some capital outflows, if not all,” he adds.

Foreigners began unwinding their holdings in early in 2015 as part of a broader outflow of funds from emerging markets as they speculated on US Fed interest rate increases. Over a 12-month period to April 2016, foreign investors halved their holdings in Treasury bills and bonds to Rs230 billion.

The Central Bank responded by increasing monetary policy rates by 50 basis points in February 2016, and again in June by the same rate. In five months, foreign investments in government securities increased 37% to Rs316 billion.

The recovery was short-lived, however. Sri Lanka’s credit profile coming under increasing pressure and the US Fed increasing interest rates, twice since November 2016, resulted in another bout of foreign selling.

“Foreign holdings in the bond market continued its freefall in March 2017, indicating further outflows in the near term,” CT CLSA Securities said in a report that month. Outstanding stocks of government securities increased 14% to Rs4.7 trillion in the two years to March 2017. However, the share of foreign holdings dwindled from 11% (Rs455 billion) to 4% (Rs197 billion).

A Central Bank rule restricts total foreign holdings to 12.5% of total outstanding Treasury bills and bonds to avoid systemic shocks that come with capital flight.

The March 2017 policy rate increase is expected to contain the outflow, improve foreign reserves and placate the IMF. “The move may likely be viewed positively by the IMF, enabling the government to receive the second tranche. This may be a catalyst towards mobilizing funds to finance external debt repayments from other agencies,” CT CLSA Securities says, raising its forecast yield for the benchmark 12-month Treasury bill by 30 basis points to 11.5% by end-2017.