Sri Lanka holds rates; credit up amid sterilized forex interventions
ECONOMYNEXT – Sri Lanka’s central bank held rates in December at 9.0 percent, while credit to the state and private sector accelerated amid money printed to enforce fixed interest rates after intervening in forex markets to maintain a soft-pegged exchange rate.
"In spite of the increased cost of funds and tight liquidity conditions, the year-on-year growth of credit to the private sector accelerated since September 2018, partly reflecting the private sector advancing its activities in anticipation of measures by the government and the Central Bank to curb excessive import growth," the soft-pegged central bank said in its December monetary policy statement.
Liquidity runs short when the central bank intervenes in forex markets to defend a peg when a run is triggered on the rupee.
In a soft-peg the central bank then prints money to fill the liquidity shortage (sterilize the intervention) and stop rates from going up and slowing credit, triggering ‘balance of payments’ pressure.
Private credit had expanded by 79 billion rupees to 5,509 billion rupees in November, growing at an annual rate of 16.2 percent, up from 16.1 percent a month earlier.
In November the central bank also dumped tens of billions of rupees in the banking system through a reserve ratio cut and expanded the ability of banks to give loans from future deposits.
A soft-pegged central bank’s monetary operations may appear as credit to government because Treasuries are used to print money into the banking system, despite budget deficits falling or not expanding.
Net credit to government from the banking system accelerated at an annual rate of 9.2 percent in October to 14 percent in November, data showed.
The SRR cut dumped 90 billion rupees in to the banking system in November to sterilize earlier interventions.
But interventions in the forex markets continued generating more shortages.
"The reduction of the Statutory Reserve Ratio (SRR) at the last monetary policy review in November 2018 released around Rs. 90 billion of rupee liquidity to the banking system," the monetary authority said.
"However, the liquidity deficit has widened thereafter, and the Central Bank continued its open market operations (OMOs) cautiously to manage liquidity on overnight, short term and long term basis as appropriate."
The central bank which was injecting printed money into banks at rates around 8.47 percent in the first week of November, injected new money at rates as low as 8.35 percent after a 50 basis point ‘rate hike’ to 9.0 percent from 8.50 percent and a cut in the reserve ration which dumped 90 billion rupees of liquidity in to the banking system.
Sri Lanka operates a highly unstable foreign reserve collecting soft-peg with the US dollar, involving a de facto external anchor with a shifting convertibility undertaking.
The regime suddenly shifts to a floating rate with a domestic anchor made up of a wide near-double-digit inflation target with unsterilized excess liquidity collected during the pegging period intact, sending the rupee sliding down forcing currency defence.
The central bank lost control of the peg in the first quarter of 2018, when the economy recovered, as it failed to mop up inflows (sterilize dollar purchases) and injected cash to generate excess liquidity in April.
Though the peg stabilized around July and August after falling sharply, unsterilized excess liquidity was against built up including through rupee dollar swaps, triggering a renewed period of pressure. The rupee has since fallen to 180 to the US dollar.
In November interventions topped 500 million dollars, amid a political crisis, which added to uncertainty.
When a soft-pegged central bank mops up inflows (liquidity from dollar purchases), the peg strengthens by squeezing credit and outflows.
But when it injects cash through open market operations, credit expands and imports grow beyond dollar inflows generating balance of payments pressure and forcing the currency down.
There have been calls to reform the central bank’s open market operations to make it more difficult for the central bank to generate monetary instability.
Critics have pointed out that the central bank cannot take the risks it did 15 or 20 years ago because Sri Lanka is now more exposed to international capital markets, and monetary instability is amplified by panicking foreign bond holders and credit downgrades, making it more difficult to recover from such periods.
The full statement is reproduced below:
Monetary Policy Review: No. 8 – 2018
The Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 27 December 2018, decided to maintain policy interest rates at their current levels. Accordingly, the Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR) of the Central Bank will remain at 8.00 per cent and 9.00 per cent, respectively. The Board considered current and expected developments in the domestic economy and the domestic financial markets as well as the global economic environment, with the broad aim of stabilising inflation at mid single digit levels in the medium term to enable the economy to achieve its potential growth.
Subpar economic growth continued in the third quarter of 2018 as well
As per the provisional estimates of the Department of Census and Statistics (DCS), the Sri Lankan economy recorded a modest real GDP growth of 2.9 per cent, year-on-year, during the third quarter of 2018, compared to the revised growth of 3.6 per cent in the second quarter of 2018. As per the available economic indicators and other economic developments, real GDP growth is likely to be low in the fourth quarter of 2018 as well, before picking up gradually in 2019. The continued low economic growth reemphasises the need for implementing broad based structural reforms without further delay. 2
Notwithstanding the elevated market interest rates and rupee liquidity deficit, private sector credit growth accelerated
The reduction of the Statutory Reserve Ratio (SRR) at the last monetary policy review in November 2018 released around Rs. 90 billion of rupee liquidity to the banking system. However, the liquidity deficit has widened thereafter, and the Central Bank continued its open market operations (OMOs) cautiously to manage liquidity on overnight, short term and long term basis as appropriate. Given high credit growth and foreign exchange market developments, overnight interest rates in the money market have been maintained close to the upper bound of the policy rate corridor. Other market interest rates remained at elevated levels, both in nominal and real terms.
In spite of the increased cost of funds and tight liquidity conditions, the year-on-year growth of credit to the private sector accelerated since September 2018, partly reflecting the private sector advancing its activities in anticipation of measures by the government and the Central Bank to curb excessive import growth. Nevertheless, with the contraction in net foreign assets of the banking system, the year-on-year growth of broad money (M2b) remained within the expected levels.
Favourable outlook for inflation in the near term
Headline inflation, based on both the National Consumer Price Index (NCPI) and the Colombo Consumer Price Index (CCPI), remained in low single digit levels. Core inflation also remained subdued thus far in 2018. Recent downward adjustments to fuel prices and selected administratively determined prices, as well as the reduction of Special Commodity and telecommunication levies, along with the ongoing recovery in the agriculture sector are expected to impact favourably on inflation in the near term. Volatile global commodity prices, possible weather related disruptions to domestic supply chains due to unpredictable weather patterns, and the possible pass-through of the effect of the rupee depreciation in recent months to domestic prices pose risks to the inflation outlook. The current projections show that inflation, on average, will remain below 5 per cent in 2019 and stabilise in the range of 4-6 per cent thereafter with appropriate policy adjustments.
External sector continues to face international and domestic headwinds
The trade deficit widened further in the first ten months of 2018 with the expansion in import expenditure outpacing the growth of export earnings. However, a moderation in import expenditure is expected, in response to the measures adopted to curb imports of motor vehicles and non-essential goods as well as the impact of the depreciation of the rupee.
While earnings from tourism continued to grow, a slowdown in workers’ remittances was observed. In the financial account, both the government securities market and the Colombo Stock Exchange experienced net outflows of foreign investment, although marginal inflows have been observed in December.
The widening trade deficit, tight conditions in the global markets and excessive speculation in the domestic market exerted pressure on the exchange rate, and the Sri Lankan rupee depreciated by 15.9 per cent against the US dollar thus far during 2018 up to 27 December. Meanwhile, gross official reserves amounted to US dollars 7.0 billion at end November 2018, providing an import cover of 3.7 months.
Policy interest rates maintained at current levels
Although inflation remains subdued and economic growth remains below potential, the Monetary Board of the Central Bank was of the view that it is appropriate to continue the current monetary policy stance to stabilise overall economic conditions and domestic financial markets in a context where there has been an uptick in private sector credit as well as continued pressure on external reserves. Accordingly, the Monetary Board decided to maintain the Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels.