ECONOMYNEXT – Sri Lanka has hiked policy rates 50 basis points to 6.50 percent amid balance of payments pressure and inflation of 12 percent after two years record liquidity injections and money supply growth.
Sri Lanka has been printing money (injecting liquidity above is external anchor) for around two years, initially creating balance of payments deficits and also gradually driving up broad money and domestic inflation.
“The Monetary Board was of the view that the above measures will curtail the possible build-up of underlying demand pressures in the economy, which would also help ease pressures in the external sector, thus promoting greater macroeconomic stability,” the central bank said.
“In keeping with this policy stance, the Central Bank expects a corresponding increase in interest rates, particularly in deposit rates, thereby encouraging savings, while discouraging excessive consumption, which also fuels imports.
“Therefore, financial institutions are urged to swiftly pass on this increase to deposit rates of the customers.”
The central bank is also mandating that tourist hotels only accept payments in US dollars, in a new dollarizing measure. Tourists hotels were already allowed to accept dollars.
Broad money growth had hit 20.1 percent by November 2020 and remained elevated on a higher base at 15.1 percent by November 2021. Inflation hit 12.1 percent by December 2021.
Central Bank Governor Cabraal in late 2021 allowed market bond rates to go up, almost fully financing the deficit without printing money.
Higher “market interest rates will facilitate the reduction in the Treasury bill holdings of the Central Bank through increased market subscriptions, as enunciated in the Six-Month Road Map for Ensuring Macroeconomic and Financial System Stability,” the central bank said.
However the central bank is caught in a classic sterilization trap without a working foreign exchange regime. Sri Lanka does have a credible peg and reserves – which are already negative – are leaking for imports.
In a working pegged regime, a central bank sell-down of Treasury bills sets off a cascading reduction in domestic credit, which reduces imports and allows the central bank to buy dollars and build up foreign reserves, which in turn can be sterilized with further outright sales of Treasury bills.
However the credibility of the peg at 200 had been lost, driving parallel exchange rates.
The central bank said it will extend its own parallel exchange rate of 10 rupees for worker remmittances till April.
Analysts have warned that reserve sales for imports – including oil – which is not accompanies by a rise in rates and a fall in liquidity (the central bank prints money to ‘sterilize’ the sale to keep a fixed overnight rate) will lead to further balance of payments trouble.
The central banks surrender requirement on exporters are also negative on the 200 to the US dollar peg, as CB purchases of dollars create new liquidity on a peg that already on its weak side. However the central bank has started repo auctions to mop up liquidity.
In a true floating rate – which is subject to an inflation target – the stock of Treasury bills held by the central bank is no relevant.
Key Measures
a) increase the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank by 50 basis points each, to 5.50 per cent and 6.50 per cent, respectively;
b) distribute the financing of essential import bills for fuel purchases among the licensed banks in proportion to their foreign exchange inflows;
c) mandate all registered tourist establishments to accept foreign exchange only in respect of services rendered to persons resident outside Sri Lanka;
d) extend the payment of an additional Rs. 8.00 per US dollar for workers’ remittances paid in addition to the incentive of Rs. 2.00 per US dollar offered under the “Incentive Scheme on Inward Workers’ Remittances” until 30 April 2022, reimburse the transaction cost borne by Sri Lankan migrant workers through the payment of Rs. 1,000 per transaction, when remitting money to rupee accounts via licensed banks and other formal channels with effect from 01 February 2022 and introduce higher interest rates for both foreign currency and rupee denominated deposits of migrant workers.
The full statement is reproduced below:
Economic activity is expected to record a gradual recovery following a temporary setback
As per the data released by the Department of Census and Statistics, domestic economic activity that was disrupted with the outbreak of the third wave of the COVID-19 pandemic and related mitigative measures is estimated to have contracted by 1.5 per cent, year-on-year, during the third quarter of 2021. However, economic activity towards the latter part of 2021 appears to have gathered momentum as several leading indicators point towards activity returning to normalcy along with the successful vaccination drive of the Government. Accordingly, the economy is expected to have recorded a growth of around 4.0 per cent in 2021.
External sector remains resilient amidst heightened challenges
With the normalisation of global economic activity, a notable improvement in export performance was observed, with monthly exports remaining in excess of US dollars 1 billion, consecutively since June 2021. Meanwhile, expenditure on imports increased significantly, partly reflecting the increased international prices, the demand for intermediate goods, and a more than expected demand for consumer goods. The increase in imports was also underpinned by the availability of low cost credit, which led the trade deficit to widen to pre-pandemic levels in 2021. Meanwhile, developments in the tourism sector appear to be promising with the influx of tourists in recent months.
Although inflows in the form of workers’ remittances have reduced somewhat in the latter half of 2021, the introduction of special incentive schemes and the actions taken by the authorities to curb illegal fund transfers have generated renewed interest in routing funds through formal channels. The Sri Lanka rupee depreciated by 7.0 per cent against the US dollar in 2021 and has been broadly stable thus far in 2022. At the same time, the Central Bank was able to fulfil the timely settlement of the International Sovereign Bond (ISB) of US dollars 500 million on 18 January 2022. As of end 2021, the gross official reserves were estimated at US dollars 3.1 billion. 2
Credit flows to the private sector continue to expand
Credit extended to the private sector, which slowed down during September and October 2021, has picked up recently, partly reflecting the increased credit flows to finance imports. In the meantime, credit obtained by the public sector from the banking system, particularly net credit to the Government, continued to expand. Despite the recent deceleration observed due to the decline in net foreign assets of the banking system, with the significant expansion in domestic credit, the growth of broad money (M2b) remained elevated by end November 2021. Meanwhile, most market lending rates have adjusted upwards, while deposit rates have also increased albeit at a slower pace. Further, yields on government securities have increased amidst enhanced market subscriptions at primary auctions for government securities.
Supply side factors remain the key driver of domestic price pressures amidst the possible signs of demand pressures
Inflationary pressures in the domestic front continued to be fuelled by supply side disruptions, upward adjustments to administered domestic prices, and the strengthening of underlying demand conditions in the economy as reflected in the rise in core inflation. Such supply driven price pressures are expected to be transitory, although the possible build-up of demand driven inflationary pressures may compel the adoption of proactive monetary policy measures, which will also help in managing inflation expectations.
Monetary and other policy measures are expected to strengthen the macroeconomic stability
In consideration of the current and expected macroeconomic developments, the Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 19 January 2022, decided to adopt several policy measures with the view to strengthening macroeconomic stability.
Accordingly, the Monetary Board decided to:
a) increase the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank by 50 basis points each, to 5.50 per cent and 6.50 per cent, respectively;
b) distribute the financing of essential import bills for fuel purchases among the licensed banks in proportion to their foreign exchange inflows;
c) mandate all registered tourist establishments to accept foreign exchange only in respect of services rendered to persons resident outside Sri Lanka;
d) extend the payment of an additional Rs. 8.00 per US dollar for workers’ remittances paid in addition to the incentive of Rs. 2.00 per US dollar offered under the “Incentive Scheme on Inward Workers’ Remittances” until 30 April 2022, reimburse the transaction cost borne by Sri Lankan migrant workers through the payment of Rs. 1,000 per transaction, when remitting money to rupee accounts via licensed banks and other formal channels with effect from 01 February 2022 and introduce higher interest rates for both foreign currency and rupee denominated deposits of migrant workers.
The Monetary Board was of the view that the above measures will curtail the possible build-up of underlying demand pressures in the economy, which would also help ease pressures in the external sector, thus promoting greater macroeconomic stability. In keeping with this policy stance, the Central Bank expects a corresponding increase in interest rates, particularly in deposit rates, thereby encouraging savings, while discouraging excessive consumption, which also fuels imports.
Therefore, financial institutions are urged to swiftly pass on this increase to deposit rates of the customers. Moreover, the anticipated adjustment in market interest rates will facilitate the reduction in the Treasury bill holdings of the Central Bank through increased market subscriptions, as enunciated in the Six-Month Road Map for Ensuring Macroeconomic and Financial System Stability. Meanwhile, the materialisation of the expected foreign exchange inflows through bilateral arrangements and other import financing arrangements with friendly countries are expected to ensure a healthy level of gross official reserves in the period ahead and further strengthen the external sector in the economy.