ECONOMYNEXT – Sri Lanka’s central bank said it is holding policy rate at which money is injected to the market at 15.50 percent, but said it may use administrative controls to bring down rates as inflation comes down.
Market rates are now about double that of policy rates. But they are half the historical inflation and have been negative in real terms for several months.
“The Central Bank would expect a moderation of excessive market interest rates, in line with the prevailing policy interest rates,” the monetary authority said in its November policy statement.
“If an appropriate downward adjustment in the market interest rates would not take place in line with the envisaged disinflation path, the Central Bank will be compelled to impose administrative measures to prevent any undue movements in market interest rates.”
The central bank has in the past enforced its policy rates when domestic credit picked up by printing large volumes of money through its policy rates and triggering forex shortages and currency crises by de-stabilizing the reserve collecting peg.
However when the breaks are put on the crisis after the credibility of the peg (and reserves) are lost, rates tend to shoot up.
High nominal rates are a generally found in monetary regimes with anchor conflicts (neither a hard peg or clean floats) analysts have said.
Sri Lanka’s central bank had imposed deposit controls after a currency crisis in 2018.
“…[T]he Board noted with concern the anomalous rise in market interest rates, particularly deposit interest rates and short-term lending interest rates, despite the recent improvements inoverall money market conditions and the adverse implications on business and economic activity,” the agency said.
Sri Lanka’ gilt yields are also high due to fears of a second real hair cut on rupee government securities.
In the past the central bank has been forced to float the currency to restore confidence in the currency after rate hikes and tax hikes reduce domestic credit, and inflows resume, helping loosen the credit system.
Analysts had warned that without a float, restoring confidence in the currency takes much higher rates.
A float isolates reserve money from the balance of payments and gives control back to the central bank and allows it to enforce a policy rate without money leaking through interventions (no reserve pass-through) or having to inject large volumes of money to enforce the policy rate, creating conflicts between money and exchange rate policy.
At the moment the central bank is intervening in both directions in a peg set at around 360 to the US dollar with a surrender rule and sales for oil and other imports.
At a basic level, a pegged exchange rate central bank which intervenes in the forex market loses control of reserve money (monetary policy independence so-called) and triggers a currency crisis when attempts are made to stop the reserve money from shrinking after forex sales.
However pegged central bank can consistently keep rates slightly higher than market, under supply reserve money and credit to build forex reserves above the monetary base (most East Asia central banks).
But enforcing a below-market policy rate with open market rates leads to forex shortages and a currency crisis if domestic credit demand is strong (most Latin America central banks).
Forex shortages and currency crises are a problem associated with reserve collecting central banks that attempt to enforce a policy rate.
The full statement is reproduced below:
The Central Bank of Sri Lanka maintains policy interest rates at their current levels
The Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 23 November 2022, decided to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 14.50 per cent and 15.50 per cent, respectively, after considering the recent and expected developments in the domestic and global economy and macroeconomic projections. The Board noted that the maintenance of tight monetary policy stance is necessary to contain any demand driven inflationary pressures in the economy, while helping to further strengthen disinflation expectations, thus enabling to steer headline inflation towards the targeted level of 4-6 per cent over the medium term.
Headline inflation marked a turnaround as expected
Supported by favourable supply side developments and tight monetary policy measures, headline inflation pivoted towards the envisaged disinflation path in October 2022, after passing the peak in September 2022. Accordingly, headline inflation, based on both the Colombo Consumer Price Index (CCPI) and the National Consumer Price Index (NCPI), decelerated, while a deceleration was observed in core inflation.
The deceleration in inflation is expected to continue in the ensuing period, supported by subdued aggregate demand pressures, expected improvements in domestic supply conditions, normalisation in global commodity prices, and the timely passthrough of such reductions to domestic prices, along with the favourable statistical base effect. Global as well as domestic risks to the inflation outlook in the near term are tilted to the downside, thereby supporting the disinflation path (Figure 01) and stabilising inflation at the desired levels towards the end of 2023.
Domestic economic activity is expected to remain tepid during 2022
The real economy is expected to contract in 2022 impacted by the stability-oriented policy measures that led to tightened monetary and fiscal conditions, along with supply side constraints and prevailing uncertainties, among others. Nevertheless, economic activity is expected to make a gradual, yet sustainable recovery, supported by envisaged improvements in supply conditions, improved market confidence, and the impact of corrective policy measures being implemented to stabilise the economic conditions.
Tight monetary and liquidity conditions have slowed the expansion of money and credit
Outstanding credit extended to the private sector by commercial banks is expected to have contracted for the fifth consecutive month in October 2022, reflecting the impact of increased market lending interest rates and the moderation in economic activity. Market deposit interest rates have also risen notably disproportionate to the adjustment in the policy interest rates. The continued excessive upward adjustment in market interest rates, despite the improvements indomestic money market liquidity and the deceleration of inflation, has resulted in persistent anomalies in the interest rate structure.
Meanwhile, yields on government securities are showing some signs of easing recently, and are expected to moderate further. Going forward, the anomaly in market interest rates is expected to be rectified, benefiting mainly from the notable reduction in the overall money market liquidity deficit and the anchoring of inflation expectations in line with the envisaged disinflation path. Further, the high risk premia attached to the yields on government securities are expected to shrink in the period ahead as the debt restructuring process progresses and fiscal sector performance improves with the consolidation measures in place.
The external sector remains resilient despite the heightened balance of payments
The merchandise trade deficit for the ten months ending October 2022 contracted significantly owing to the robust export earnings and a substantial decline in import expenditure due to policy measures taken to curtail demand for imports, amidst the shortage in foreign exchange.
Workers’ remittances are expected to improve in the period ahead with rising departures for foreign employment, while the tourism sector is set to mark an improvement in view of the upcoming season for tourist arrivals. Amidst the improvements observed in liquidity in the domestic foreign exchange market, the Central Bank continued to facilitate the import of essential goods to ensure the availability of energy, power and other supplies necessary for uninterrupted economic activity.
Meanwhile, the exchange rate remained broadly stable. The gross official reserves were estimated at US dollars 1.7 billion as of end October 2022, including the swap facility from the People’s Bank of China, equivalent to around US dollars 1.4 billion, which has certain conditionalities on usability. Risks to external demand could emerge amidst moderating global growth prospects in the near term, however, rising prospects of the tourism sector and workers’ remittances would help offset any negative spillovers to a large extent.
Policy interest rates are maintained at current levels as conditions are sufficiently tight
In consideration of the current and expected developments, both locally and globally, as indicated above, the Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 23 November 2022, decided to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 14.50 per cent and 15.50 per cent, respectively. The Board was of the view that the prevailing tight monetary policy stance is necessary to rein in any underlying demand pressures in the economy.
However, the Board noted with concern the anomalous rise in market interest rates, particularly
deposit interest rates and short-term lending interest rates, despite the recent improvements inoverall money market conditions and the adverse implications on business and economic activity.
The Central Bank would expect a moderation of excessive market interest rates, in line with the prevailing policy interest rates. If an appropriate downward adjustment in the market interest rates would not take place in line with the envisaged disinflation path, the Central Bank will be compelled to impose administrative measures to prevent any undue movements in market interest rates.
At the same time, the Board reiterates its continued commitment to restoring price stability and ensuring financial system stability, and remains confident that inflation would follow the projected disinflation path underpinned by the prevailing monetary policy stance, while supporting the economy to reach its potential over the medium term.
Further, the Board remains ready to react appropriately to any materialisation of risks to the forecast