ECONOMYNEXT – Sri Lanka’s central bank has cut its policy corridor by 50 basis points with to 7.50 percent and 8.50 percent as a credit contraction has made the floor rate the active policy rate.
Sri Lanka’s credit has contracted in early 2019, following prolonged liquidity shortages to defend the currency which collapsed amid liquidity injections.
"Following a higher than projected credit expansion, particularly in the latter part of 2018, credit extended to the private sector by commercial banks contracted, in absolute terms on a cumulative basis, during the first four months of 2019," the central bank said.
"High market lending rates, sluggish growth in economic activity, subdued business confidence, as well as the settlement of arrears by the government on account of various projects which enabled repayments to the banking sector, were amongst the factors which contributed to this contraction."
In the first quarter bank balance sheets were seen contracting.
Credit to private sector from commercial banks fell to 5,544 billion rupees in April 2019 from 5,561 billion rupees in December.
The contraction was also helped by government settlement arrears to contractors, which is a positive factor and also helps cut bad loans. Government borrowings from the banking system has also eased helpd by foreign loans.
Analysts had warned of an output shock following prolonged liquidity shortages due to the operation of a soft-pegged exchange rate with contradictory policy.
Sri Lanka’s economic troubles mostly stem from a soft-pegged exchange rate regime set up in 1950, but monetary instability has worsened in recent years.
In 2018 monetary instability was triggered by two liquidity shocks as the economy recovered, but a political crisis from October made it difficult for the central bank to follow any other policy, analysts have said.
The central bank said lending rates have not fallen yet, despite its controversial recent price controls on deposit rates.
Analysts have called on the central bank halt its overnight and short term repo operations to help rates fall at least to the floor policy rate. Unlike in 2018, no money printing is required for rates to fall, as credit is contracting.
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Though the floor policy rate was 8.0 percent, as late as Thursday, the central bank’s domestic operation department was withdrawing excess liquidity at around 8.50 percent, keeping rates higher than the free market rate.
To ‘cut’ rates no money printing is now required unlike in 2018.
The central bank said growth is likely to fall after Easter Sunday blasts in April, though there was a pick up in industry and agriculture in the first quarter.
"Although normalcy is gradually returning to economic activity, a lower than initially projected growth could be anticipated during 2019," the central bank said.
"Along with the developments in the domestic financial markets so far during the year, the monetary policy decision to reduce policy interest rates is expected to induce a swift and sizable reduction in market lending rates."
Inflation had picked up to 4.5 percent in April after falling to 2.8 percent in December, partly due to currency depreciation the central bank said. However it is expecting inflation to be around 4-6 percent with weak growth.
Analysts had warned that Sri Lanka may be hit by stagflation, as an inflation target ceiling under a program with International Monetary Fund, was too wide to maintain monetary stability.
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