Sri Lanka ceiling rate cut ends tightening phase of monetary policy: CB Governor

ECONOMYNEXT – A cut it Sri Lanka’s ceiling policy rate by 25 basis points to 8.50 percent, was to signal that a tightening cycle with inflation falling and growth also slowing, Central Bank Governor Indrajit Coomaraswamy said.

"The monetary board (the governing board of the central bank) felt it is timely at this juncture to give signal that the tightening phase of monetary policy should end now," Governor Coomaraswamy said.

"Up to now there had been a strong period a tightening bias to monetary policy, though growth was coming down the Central Bank maintained a tightening bias we saw last quarter."

Last year growth fell to 3.1 percent, with a drought weakening agriculture, dampening hydro power generation, while 1.4 billion dollars was collected as forex reserves, depriving resources from the banking system to the domestic economy.

In a soft-pegged monetary system, when a balance of payments crisis triggered by a credit bubble fired by money printing and deficit spending ends (Keynesian stimulus), losing forex reserves temporarily boosting activity, a slowdown follows when reserves are re-built with slowing credit.

Currency depreciation also pushes inflation up, killing purchasing power, impoverishing people and dampening consumption. Currency collapses and slowdowns increase economic hardships of the people, generating political instability.

Governor Coomaraswamy said Sri Lanka’s potential growth had been estimated at 5.7 percent and last year’s growth was only 3.1 percent, increasing the ‘output gap’ to 2.6 percent.

But late last year, the central bank had kept rates unchanged as inflation was still high partly due to higher food prices from the drought, but rates were not cut, to prevent inflation expectations from worsening. But now inflation was falling.

Though there was not official rate cut in practice however benchmark overnight rates had fallen over 100 basis points due to the wide policy rate corridor towards the lower 7.50 percent floor, as credit slowed.

When credit slows and foreign reserves were collected through dollar purchase, excess liquidity builds up and rates fall, making the floor policy rate the active rate as rates halt there.





In the last week, overnight rates moved up sharply, rising as much as 8.65 percent towards the 8.75 percent ceiling rate, due to higher cash demand during the festive season draining excess liquidity and forex purchases ending. The ceiling rate cut will keep overnight rates at 8.50 percent.

Regardless of the rate, sterilized forex purchases also creates a situation of ‘quantity tightening’ if foreign reserves continue to be collected, though strong capital inflows can moderate the tightening.

Soft-pegged regimes are among the most dangerous monetary systems ever devised and many countries that adopted such systems entering the Bretton Woods system ended up with high inflation, currency collapse, exchange controls and political instability.

Meanwhile Governor Coomaraswamy said the budget deficit at 5.5 percent in 2017 was higher than targeted by fiscal performance had improved from a year earlier. He expected fiscal situation to be stable at least until June.

He said Sri Lanka also had to take into account Federal Reserve rate hikes of which there may be three or even four in 2018.

Narrowing interest rates between the US and Sri Lanka could lead to capital outflows. (Colombo/April04/2018)

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