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Sri Lanka maintains loose monetary policy amid currency slide

ECONOMYNEXT – Sri Lanka’s central bank has maintained its low policy rates in a September monetary policy decision amid a slide in the currency, forex reserve losses, capital flight, rising domestic credit, and an expanded budget deficit.


Domestic Anchor

The Central Bank said year on year inflation was -0.2 in August, but core inflation had risen to 3.9 percent in August from 3.5 percent a month earlier.

Core inflation comes mainly from non-traded goods and services. Headline inflation is down as a rising US dollar pushed down commodity prices.

But the Central Bank said it was holding its policy corridor at between 6.0 percent and 7.50 percent.

It has a so-called soft-pegged exchange rate arrangement where it prints money and tries to control the exchange rate at the same time, sliding in to balance of payments crises or high inflation or both.

As it targets and exchange rate which is an external anchor, economists have pointed out that the Central Bank cannot also target a domestic anchor in the form of an inflation index, when state and private credit is high.

Private credit has grown 21 percent in July with 40.9 billion rupees in new credit given in the month. No data was given for state borrowings from the banking system for July.

Central Bank Credit





Analysts have pointed out that in addition to low interest rates, the Central Bank was monetizing debt and injecting cash in to the banking system at below the 7.5 percent ceiling rate by purchasing Treasury bills outright.

In addition to defending an overnight rate like normal central banks do, Sri Lanka’s monetary authority was now defending at least a three month rate by quantity easing despite a deteriorating budget deficit and soaring private credit.

Since June about 170 billion rupees had been printed to finance the deficit and to keep interest rates down.

The Central Bank ended open intervention in the spot forex markets on September 04, with the rupee at 134.75 to the US dollar, but data shows that backdoor interventions are continuing with a new peg appearing to develop around 141.00.

Leading Indicators

Analysts had pointed out for several months, that that low interest rates maintained by injecting tens of printed rupee reserves into the banking system was promoting consumption and credit especially into motor vehicles which were ignored.

Earlier this month the Central Bank reduced the share of credit that can be financed in a motor vehicle.

"The increased credit flows to the private sector have been sustained mainly due to prevailing low market interest rates amidst low inflation environment," the Central Bank said.

"Meanwhile, the Central Bank has observed with concern the recent rapid growth of exposure of banks and financial institutions to certain categories of lending, in particular lending in respect of motor vehicles."

Instead of engaging in fire-fighting administrative controls in each sector that is a leading indicator of imprudent monetary policy, the Central Bank should stop printing money in large quantities, analysts say.

Second hand car prices have also risen over the past few months, in a classic asset price inflation and leading indicator that was also seen in 2011 at the start of Sri Lanka’s last balance of payments crisis.

Reserve Losses

Sri Lanka’s foreign reserves had fallen to 6.4 billion US dollars in August down from 9.1 billion dollars a year earlier, out of which 400 million dollars were recently borrowed from a swap from the Reserve Bank of India. Another 1.1 billion dollars was drawn down in September.

The rupee has depreciated 7 percent against the US dollar so far this year, the Central Bank said.

"The recent depreciation of the exchange rate, which would enhance exports, while curtailing nonessential imports, is expected to have a favourable impact on the trade balance," the Central Bank said.

"Such improvement, together with regular inflows of workers’ remittances and earnings from tourism along with other inflows to the services account would help narrow the deficit in the current account balance and strengthen the resilience of the external sector."

The Central Bank is also hoping that government foreign borrowings will help boost reserves.

"…[O]fficial reserves are expected to increase during the remainder of the year with the expected long term external financial flows to the government," the Central Bank said.

Large government inflows however cannot be retained as Central Bank forex reserves with high domestic credit growth and fiscal profligacy.

All such inflows through the financial account or capital account will promptly flow out as they used to bridge a budget deficit, generating a trade deficit and expanding the current account, unless any forex purchases were sterilized by sell-down of Central Bank’s Treasury bills at an appropriate interest rate.

Sri Lanka’s central bank has generated high inflation and balance of payments pressure ever since it was created in 1951. (Colombo/Sept25/2015).

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