Sri Lanka cuts ceiling policy rate 25bp, corridor narrowed
Apr 04, 2018 07:46 AM GMT+0530 | 0 Comment(s)
ECONOMYNEXT - Sri Lanka's central bank has cut its ceiling policy rate by 25 basis points to 8.50 percent, and kept the floor rate at 7.25 percent, narrowing its policy corridor, to give it greater control to push interest rates down by printing money.
The rate cut comes as money and debt markets reacted to recent tax changes by moving upwards.
"..[T]he favourable developments in inflation, inflation outlook and the trends in the monetary sector, along with the lacklustre performance in economic growth, were viewed as factors supporting some relaxation of the monetary policy stance," the central bank said its April 2018 monetary policy statement.
"In the meantime, risks arising from global economic developments and the domestic fiscal front were identified as factors that need to be closely monitored, going forward."
Though this is the 'official' rate cut since the end of Sri Lanka's 2015/2016 balance of payments crisis, but the wide policy corridor meant that benchmark overnight rates moved down from 8.75 percent towards 7.25 percent without benefit of a rate cut, showing the value of a wide policy corridor.
Market Rate Moves
Over the past year the central bank had been a net purchaser of foreign exchange as credit slowed, generating excess liquidity and overnight market rates have moved towards the floor rate, effectively pushing down the benchmark overnight rate without a rate cut.
However the over the past two weeks, partly due to excess demand for cash in the run up to the April festival season, excess liquidity ran out, pushing overnight rates towards the ceiling rate of the corridor.
The central bank believes rate increase was 'undue'.
"In the monetary sector, in spite of the increase in credit to the public sector by banks, the growth of both broad money supply and credit extended to the private sector remained subdued during the first two months of 2018," the central bank said.
"Most market interest rates have stabilised at high levels, while real interest rates indicated an upward trend with declining inflation.
"However, an undue increase in short term market interest rates was observed recently, requiring the Central Bank to take corrective operational measures to address such volatility."
Longer term interest rates in government securities also moved up after a final withholding tax on bonds at 10 percent ended, and a 28 percent income tax replaced it.
No credit was given to old bonds on which taxes had already been paid, in an expropriationary move, leading to capital losses to existing bondholders as rates moved up, critics say.
In general markets are now trading at the so-called 'gross rate' of gilts, which is the same rate that the government notionally paid earlier. The market is digesting the changes.
A tax differential between government debt and bank deposits coming into effect from April 01 also drove out individuals from bonds. Analysts had warned about the problem for months but e warnings were ignored.
The central bank is due to meet market participants early Wednesday.
Meanwhile amid the tax changes the gap between the gilt backed overnight money market (repo) and clean money all but disappeared.
At the moment there is only a narrow risk premium to clean money compared to gilt backed deals. Analysts say markets will eventually adjust.
On March 29, the weighted average overnight repo rate jumped to 8.21 percent from 7.66 a day earlier, while the money rate was 8.49 percent.
The rate cut by 25 basis points will keep the overnight rate below 8.5 percent. However if the central bank prints money to enforce a lower rate, it may put the currency under pressure as it had done before.
Dealers will also get a massive funding gap, which may lead to portfolios being financed with printed money.
Under Governor Indrajit Coomaraswamy, however the central bank had not intervened in forex markets to sell dollars, though it has purchased dollars and mopped up liquidity, keeping the monetary system tight.
Over the past couple of weeks, cash locked up by the central bank through term repos deals had already been released to the market.
However reserve money had also moved up with notes in circulation going up amid the festival season.
The central bank cut rates despite concerns over state borrowings, and lower than expected fall in the budget deficit, though it said the overall picture had improved.
"Fiscal slippages in spite of the government’s efforts towards consolidation caused the overall fiscal deficit to deviate from its envisaged path in 2017," the central bank said.
"However, notable improvements were observed in tax revenue collection and current expenditure, helping the government to record a primary surplus and a moderation in the debt to GDP ratio in 2017.
"The implementation of the Inland Revenue Act (IRA) with effect from 1 April 2018 along with other reforms to improve revenue administration are likely to support fiscal performance in the period ahead."
There are also concerns that energy utilities will not be able to market-price or implement a price formula amid current political unrest.
The central bank said it had bought 1,664 million dollars in 2017 and 400 million dollars so far in 2018, with cash being mopped up.
If credit picks up and money is printed to enforce a policy rate, the central bank will not be able to collect forex reserves.
"Supported by the moderation in inflation during the first quarter of 2018 and the gradual depreciation in the nominal exchange rate, the real effective exchange rate (REER) indices recorded a gradual adjustment, thereby augmenting the country’s competitiveness," the central bank said.
A weakening exchange rate and higher inflation, which destroys real salaries however had created unrest. Airport workers struck yesterday demanding a 10,000 rupee salary increment.