Sri Lanka keeps rates unchanged in March amid gilt yield rise

COLOMBO (EconomyNext) – Sri Lanka kept policy rates unchanged in March following a tightening in February and said inflation is expected to remain low and private credit and economic activity to keep growing.

On February 27, the Central Bank closed a 5.0 percent window where excess liquidity was deposited, pushing up overnight rate to around 6.5 percent, while a fully auction-based system for goverment securiies has also pushed up the risk free yield curve.

The changes are yet to be fully reflected in the banking system, which is still flushed with excess liquidity which the Central Bank has failed to sterilize permanently and can be used to finance future credit.

In January private credit was a positive 21 billion rupees, sharply down from Decembers 76 billion rupees, the Central Bank said in its March monetary policy statement.

"Credit to the private sector from commercial banks is expected to sustain its growth momentum in the period ahead benefiting from low market interest rates and increased business confidence," the statement said.

"Despite some upward movements in interest rates in certain market segments, the low interest rate environment is expected to continue, benefiting from the prevailing low inflation levels in the economy, thus providing an impetus to economic activity."

No mention was made of state enterprise credit or bank borrowings by the central government.

Sri Lanka’s statistics office said the economy grew 7.4 percent in 2014. Consumer prices only rose 0.6 percent in the year to February 2015, partly due to tax cuts.

The Central Bank said it expected higher inflows from tourism, workers remittances, and net foreign receipts to the government, banking sector and private corporates in 2015, but imports would reduce.

However analysts say if there are higher receipts and private and state credit picks up, imports would also go up when such inflows are spent.

A fall in oil prices for example would increase disposable of economic agents within the country who may increase consumption of non-oil goods triggering more imports or increase savings.

The savings will also eventually generate imports if the credit system is more active than last year.

If the credit system becomes active enough to generate loans over and above savings and loan repayments, and use up excess liquidity collected in the past, there may be foreign reserve losses through unsterilized exchange rate defence as well as an expansion in the current account deficit.

Though there may be forex reserve losses, unsterilized currency defence is not a danger to economic stability.

By mopping up excess liquidity, unsterilized exchange rate defence matches money supply to the balance of payments in a regime where the exchange rate is targeted explicitly or de facto.

A pick up in imports, which denotes higher domestic economic activity overall, will also boost state revenues, helping finance extra spending in a revised January budget.

Any capital outflows, including a pulling back of foreign investors from rupee Treasury bills or a sharp increase in loan repayments that can reduce a financial account surplus or push it into deficit territory can reduce imports.

The increase in policy rates last month and a rise in risk free rates however would also eventually increase savings, helping counter any negative effects from an expansion of the budget deficit.

The new administration’s commitment to auction and market price domestic debt through auctions would also help maintain external stability as well as low inflation, analysts say.

In Sri Lanka balance of payments crises and high inflation occur when central banks print money, either to buy Treasury bills to finance the deficit, sterilize foreign exchange interventions or lend from the liquidity window to state banks to re-finance Treasury overdrafts.