Sri Lanka Special Report – The current depreciation of the LKR is probably an overshoot

Why we think the current depreciating trend of the LKR is short term

We think the sharp depreciation over the last few weeks was driven by the timing of multiple sources of FX outflows from the country, as opposed to a structural deterioration of Sri Lanka’s external position. Within this context, we broadly find three main factors that have played a significant role.

On one avenue, the spike in oil prices since the start of the US-Iran war is a big factor. In another avenue, with this price hike, higher volumes, and some level of frontloading of imports, as well as specific FX debt repayments, compounded during a short window. As a result, the currency weakened significantly in a small period. However, we think this could reverse to some extent, as there have been some positive forces in play. This is likely to be seen primarily with multilateral disbursements and announcements from the government’s side that indicate some level of comparative reduction in oil bills in the upcoming months.

Keeping this in mind, we still hold two broad views on how the current conflict could play out; a prolonged conflict at a decreasing intensity, as well as a short escalation with significant intensity. In either case, we think that the currency could reverse its current depreciatory trajectory, albeit at different paces, given that the structural strength in Sri Lanka’s macroeconomic story has not reversed its course.