Sri Lanka holds policy rates as rupee falls, bond yields soar

ECONOMYNEXT – Sri Lanka’s central bank said it is keeping the policy rate at which cash in injected to the banking system at 8.0 percent, with the rupee crashing to a new low and foreign investors fleeing bond markets.

The rupee fell to a fresh low of close to 149 to the US dollar in the one week forward market which has now become the reference rate for the domestic currency, with the central bank keeping the official ‘spot’ rate at 143.90 to the greenback.

The central bank triggered a balance of payments crisis by keeping rates low and printing 200 billion rupees of cash to undermine credibility of the country’s soft-dollar peg and spook foreign investors into dumping rupee bonds.

Market rates have however started to move up, and banks are hiking deposit rates as currency defence mopped up some of the money printed by the central bank (partially sterilized interventions).

In January private sector credit grew 43.6 billion rupees, the Central Bank said, which analysts say is a reasonable volume for the deposits raised though state borrowing from banks was not given.

"Going forward, the growth of monetary aggregates is expected to decelerate gradually over the remainder of the year, reflecting the impact of the upward movement in market interest rates…" the Central Bank said in its March monetary policy statement.

Expected tax hikes will also held reduce money growth, the central bank said.

As a result policy rates will not be raised, the central bank said.

The central bank has given various excuses over the past year not to raise rates and trigger the BOP pressure.

On Tuesday banks borrowed 20 billion rupees from the overnight reverse repo window at 8.00 percent to replace cash mopped up by currency defence (sterilized interventions), and some market participants were paying as much as 8.75 percent for gilt backed overnight deals.





Though private credit appears to be slowing, analysts warn that the central bank still put pressure on the currency by purchasing Treasury bills and permanently injecting liquidity in a ‘quantity easing’ manoeuvre to boost credit volumes above the total deposits raised by the banking system.

Even injecting overnight cash will put pressure on the currency, but as long as cash is only given overnight, banks will eventually slow credit as they do not like to lend long with reverse repo money.

But the practice of the central bank during past balance of payments crisis has been to buy Treasury bills outright and inject permanent liquidity, when overnight volumes exceed about 20 billion rupees.

During the current balance of payments crisis, interventions were sterilized more than 100 percent. When large volumes of money is printed domestic private credit and imports go up.

Repaying maturing bills with printed money also makes it difficult to repay foreign debt.

EN’s policy analyst Bellwether say it is a popular Mercantilist fallacy dating back to the 1920s that weak exports or a trade deficit has something to do with the inability to repay foreign debt, when the real cause was monetary instability.

The popular Mercantilist fallacy is also known as the "transfer problem".

Ironically failed Treasury bill auctions came while rates for long bonds are see-sawing giving unprecedented chances for some primary dealers to make money.
The full statement is reproduced below:

According to provisional estimates of the Department of Census and Statistics (DCS), the Sri Lankan economy grew by 4.8 per cent, in real terms, in 2015 compared to 4.9 per cent in the previous year. The expansion of the economy in 2015 was mainly supported by services related activities, which grew by 5.3 per cent during 2015. Agriculture and industry related activities also contributed positively to the growth during the year, expanding by 5.5 per cent and 3.0 per cent, respectively. The growth in 2015 was largely driven by an increase in consumption demand, while investment activities witnessed a deceleration.

Headline inflation (year-on-year) based on the Colombo Consumer Price Index (CCPI, 2006/07=100) increased to 2.7 per cent in February 2016, compared to 0.9 per cent in January 2016, mainly due to the dissipation of the base effect. Annual average headline inflation also edged up to 0.9 per cent in February 2016 from 0.7 per cent in the previous month. In line with these movements, year-on-year headline inflation, based on the National Consumer Price Index (NCPI, 2013=100), also increased to 1.7 per cent in February 2016 from negative 0.7 per cent recorded in the previous month, and was 2.6 per cent on an annual average basis. Meanwhile, the increasing trend witnessed in CCPI based core inflation continued into February 2016 as well, with core inflation registering 5.7 per cent, on a year-on-year basis, in comparison to 4.6 per cent in the previous month. Going forward, with the policy measures already adopted by the Central Bank, inflation is expected to remain in low- to mid-single digit levels during the remainder of the year.

On the external front, the deficit in the trade account narrowed by 9.1 per cent, year-on-year, in January 2016 as the decline in expenditure on imports has been greater than the decline in 2 earnings from exports. Earnings from tourism are estimated to have increased by 19.4 per cent in February 2016, while workers’ remittances, which declined by 0.5 per cent during 2015, recorded an increase of 8.0 per cent during January – February 2016. Gross official reserves, which stood at US dollars 7.3 billion at end 2015, are estimated to have decreased to US dollars 6.6 billion by end February 2016, mainly due to debt service payments and the supply of foreign exchange to the domestic foreign exchange market largely to cover the demand arising from foreign investors who moved their funds away from the government securities market. Meanwhile, the Sri Lanka rupee remained broadly unchanged against the US dollar thus far during 2016.

In the monetary sector, market interest rates have risen, reflecting the tightening monetary conditions and the transmission of policy actions of the Central Bank. The year-on-year growth in broad money (M2b), which responds to monetary policy actions with a time lag, remained high at 19.1 per cent in January 2016 in comparison to 17.8 per cent recorded at end 2015. Private sector credit growth was 25.7 per cent in January 2016 compared to 25.1 per cent in December 2015 and 27.0 per cent in November 2015. In absolute terms, private sector credit grew by Rs. 43.6 billion during January 2016. Going forward, the growth of monetary aggregates is expected to decelerate gradually over the remainder of the year, reflecting the impact of the upward movement in market interest rates, while the envisaged fiscal consolidation path is expected to support the moderation of monetary expansion.

C¬ove, the Monetary Board, at its meeting held on 29 March 2016, was of the view that the current monetary policy stance is appropriate and decided to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank unchanged at 6.50 per cent and 8.00 per cent, respectively.


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