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Sri Lanka tightens monetary policy under new CB Governor

Jul 29, 2016 06:13 AM GMT+0530 | 0 Comment(s)

ECONOMYNEXT - Sri Lanka raised its policy rate at which printed money is 50 basis points to 8.50 percent, reducing arbitrage profits to lenders and primary dealers who overtrade mis-using overnight cash from the liquidity window.

The rate setting Monetary Board in its July policy statement said it was "of the view that further tightening of monetary policy is required to curb excessive demand in order to pre-empt the escalation of inflationary pressures and to support the balance of payments," ending a litany of excuses over several months as to why rates should not be raised despite rising inflation.

Analysts say it also shows the firm resolve of newly appointed Governor Indrajit Coomaraswamy to keep the economy on a stable path.

Earlier on Thursday he said macro-economic stability was needed for strong and sustained growth.

"We do not think there are quick fixes," Coomaraswamy told the country's stock broker community.

"I think trying to create sugar highs by artificially trying to boost to boost asset markets or growth or anything else is not possible."

He said the central bank will focus on delivering economic stability, recalling the words of Karl Schiller, West Germany’s Economics Minister in 1966, who said: "Stability is not everything, but without stability, everything is nothing."

The Deutche Mark was perhaps the strongest currency in the Bretton Woods system of collapsed soft-pegs, underpinning its 'social market economy' and the country became an export power house after World War II, while the UK, which won  the war, became a shadow of its former self, beset by currency collapses, becoming a victim of loose monetary policy.

The central bank said private credit rose 28 percent in the 12-months to May almost at the 28.1 percent in April.

The hike will narrow the gap with 3-month term deposit which have been raised to 9.75 to 10.00 percent by banks who are scrambling to raise real deposits to fund credit.

Monetary instability and balance of payments pressure is caused by central bank accommodated credit, over and above deposits raised by banks, when the monetary authority purchases of Treasury outright with printed money or injects cash through reverse repo window operations.

The central bank generated the current balance of payments crisis by releasing over 300 billion rupees of inflows previously sterilized through term repo contracts, cutting rates in April 2015 despite rising state and private credit and purchasing Treasuries outright from June 2015.

Several primary dealers had been borrowing consistently through the window to purchase Treasuries, putting pressure on the balance of payments, analysts say.

Over July the central bank did not permanently accommodate liquidity shorts coming from exchange rate defence but only injected overnight cash, which is also a monetary tightening move, compared to past practice, analysts say.

The liquidity shortfall rose to 58 billion rupees by July 20 with the central bank's Treasury bill stock rising to 290 billion rupees, up from zero before the crisis. By July 27, net injections had fallen to 30.5 billion rupees and the total Treasury bill stock to 260 billion rupees.

As long as bank credit or dealers purchases of Treasuries are funded by real deposits or customer funds, an equal amount of consumption is slashed to finance the lending, keeping aggregate demand unchanged. Both commercial banks and dealers have window access.

There were concerns earlier that the window rate was kept low to allow aggressive dealers to make large arbitrage profits from long term bond purchases. Now the arbitrage opportunity has narrowed.
 
Overnight accommodation halted the deployment of the central bank's most deadly monetary policy instrument - the rejection of market bids and buying Treasury bills at auctions. As long Treasury bill auctions fail, no amount of rate hikes will prevent balance of payments pressure and 'dollar shortages' analyst warn.

"The rejection real bids at Treasuries auctions is the elephant in the room among Sri Lanka's monetary policy instruments that is mysteriously not mentioned in any textbooks," says EN's policy columnist Bellwether.

"Ironically it is deployed pro-cyclically at the worst time, when the budget deficit is rising and the monetary system is becoming de-stabilized and bank rupee reserves should not be boosted to make artificially booms."

Sri Lanka's rupee has already collapsed from 131 to 147 to the US dollar, due to loose and contradictory exchange and monetary policies (sterilized forex sales).

"The increasing trend in both headline and core inflation continued, reflecting the rise in demand driven inflationary pressures in the economy," the Central Bank said.

"Supply side disruptions arising from adverse weather conditions and the revisions introduced to the tax structure by the government also contributed to the upward movement in inflation in the past two months."

A fall in the currency pushes up prices of exports and imports (traded sector) which takes time to feed into the non-traded sector.

Since Sri Lanka has a managed float (a soft-peg) to the US dollar, the country any way imports US inflation. Over the past year, the US dollar has strengthened amid some policy tightening, pushing down commodity prices, masking the immediate effects of currency depreciation. (Colombo/July29/2016)


 

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