ECONOMYNEXT – Sri Lanka’s central bank said it was holding its policy rates at 15.50 percent, while data showed market interest rates are close to twice the rate while private credit and imports falling as a consequence.

The central bank is injecting 740 billion rupees of overnight money to banks at 15.50 percent, which were originally injected mostly after reserves were sold for imports (or debt repayments) to artificially keep down rates (sterilized interventions), effectively engaging in monetary financing of imports.

The injections (sterilizing outflows) prevent the credit system from adjusting to the outflows and encourage unsustainable credit without deposits, which is the core problem with soft-pegged central banks, triggering a high rate and an economic slowdown later.

A severe correction is now taking place with prime lending rate around 25 percent and the three-month Treasury bill yield around 29 percent.

By June there was a slowdown in private credit making more private savings available to finance the deficit rates were coming down, when concerns were raised about the possibility of re-structuring domestic debt, pushing up rates again.

“Growth of credit to the private sector is on a declining trend,” the central banks said in its August monetary policy statement.

“The year-on-year growth of credit granted to the private sector slowed down notably in June 2022, with a contraction in absolute terms over the previous month, reflecting the impact of significantly high effective market interest rates and moderation of economic activity.”

“With increasing interest rates, a notable deceleration in the growth of credit to the private sector and broad money supply is expected in the period ahead.”

Related Sri Lanka private credit negative in June 2022, Rs189bn printed

Sri Lanka’s private sector is the net saver and is unable to trigger any external pressure or balance of payments deficit, unless the central injects rupee reserves into the banking system.

Rupees reserves are sometimes injected into the banking system to finance deficits, but mostly to re-finance maturing debt from past deficits and suppress Treasuries yields (price controls on maturing securities in this currency crisis), and regularly to sterilize interventions, drive unsustainable private credit and trigger forex shortages.

Forex shortages are a problem associated with soft-pegs, where an intermediate regime central bank suppresses interest rates with liquidity injections, targeting an inflation index despite operating a reserve collecting peg (dual anchor conflict) and are absent in currency boards or clean floats.

Sri Lanka still does not have a consistent single anchor regime and some interventions are still made for imports using deferred dollars due to India under the Asian Clearing Unions (weak side convertibility) while the peg is also pushed down with a surrender requirement (strong side convertibility) leading to excess liquidity, particularly at banks with dollar inflows who have curtailed credit.

Excess liquidity in plus banks was 286 billion rupees on August 17 with 744 billion rupees injected to banks which had made loans without deposits and triggered deficits in the balance of payments.

A float is usually required to snap the credit system out of a peg which has lost credibility, end sterilized interventions, which then leads to a faster fall in interest rates. Net foreign assets begins to turn when the currency is re-pegged after a successful float.

“Net foreign assets of the banking system continued to contract, weighing down the expansion of broad money supply,” the central bank said.

Extended operations of non-credible pegs can lead to be bigger output shocks and bad loans due to higher rates.

Attempts to suppress rates when private credit recovers in a pegged regime are followed by steep reserve losses, collapses of the currency, higher inflation and very steep rises in interest rates and an economic output shock.

Sri Lanka’s gross domestic product contracted 1.6 percent in the first quarter of 2022 and other projections are in excess of 7 percent.

Amid “already recorded negative growth in Q1 2022 and contractionary policies, could result in a larger than expected contraction in real activity in 2022,” the central bank said.

“Contractionary monetary and fiscal policies already in place, alongside the measures to curtail non urgent import expenditure, are expected to result in a notable contraction in credit to the private sector and possible upside risks to unemployment in the near term.”

However lack of credit, which reduces the ability of the banking system to push printed money to the broader economy and create further imbalances, is expected to slow inflation.

Data also shows a steady contraction in the monetary base, pointing to a real fall in demand for money and economic activity, despite continued anchor conflicts.

Sri Lanka has gone to the IMF 16 times with broken pegs and this time the country has also defaulted after taking on a large volume of commercial debt.

As a result the IMF program is not limited to hiking rates and raising taxes to fix imbalances, but the debt also has to be re-structured with foreign creditors no longer willing to rollover debt.

“Negotiations with the IMF towards reaching a staff-level agreement on the Extended Fund Facility (EFF) arrangement are scheduled in coming weeks, while expeditious measures are being taken to advance the debt restructuring process with the assistance of financial and legal advisors,” the statement said.

Monetary Policy Review: No. 06 – August 2022

The Central Bank of Sri Lanka maintains policy interest rates at their current levels
The Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 17 August 2022, decided to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 14.50 per cent and 15.50 per cent, respectively. In arriving at this decision, the Board considered the latest model-based projections, which point towards a larger than expected contraction in activity and a faster than expected easing of price pressures, compared to the previous monetary policy review.

Contractionary monetary and fiscal policies already in place, alongside the measures to curtail non urgent import expenditure, are expected to result in a notable contraction in credit to the private sector and possible upside risks to unemployment in the near term. The Board was of the view that despite headline inflation is projected to remain elevated in the near term, the policy measures taken by the Central Bank and the Government thus far would help contain any aggregate demand pressures, thereby anchoring inflation expectations, along with the anticipated decline in global commodity prices and its passthrough to domestic prices in the period ahead.

Global economic growth is expected to slow at a faster pace

As per the July 2022 update of the World Economic Outlook (WEO) of the International Monetary Fund (IMF), global economic growth is estimated to moderate to 3.2 per cent in 2022 from 6.1 per cent recorded in 2021. Tighter financial conditions adopted by central banks around the world following the emergence of inflationary pressures, a slowdown in Chinese economy due to the resurgence of COVID-19, among others, and further negative spillovers from the geopolitical tensions in Eastern Europe have dampened global growth prospects.

Global inflation remains high mainly due to elevated energy and food prices as well as supply-demand imbalances, while downside risks emerge in the outlook for global inflation in the near to medium term.

Domestic economic activity is expected to record a notable downturn

The impact of persisted supply side disruptions, primarily due to shortages of power and energy, and uncertainties associated with socio-political developments are expected to have caused significant adverse effects on economic growth in Q2 2022, while such impact is expected to have continued through Q3 2022 as well.

That, coupled with the already recorded negative growth in Q1 2022 and contractionary policies, could result in a larger than expected contraction in real activity in 2022. However, real GDP growth is expected to recover in the period ahead, with the envisaged stabilisation of macroeconomic conditions and implementation of structural reforms in the economy.

Despite heightened challenges, positive developments are observed in the external sector

Merchandise trade deficit continues to decline in cumulative terms, reflecting mainly the impact of policy measures to curtail non urgent imports, while earnings from exports continue to remain high.

Foreign exchange inflows in the form of workers’ remittances remain lower than expected, while improvements are observed in the tourism sector, with increasing tourist arrivals.

Pressures witnessed in the domestic foreign exchange market have eased to a large extent with the notable decline in import expenditure and improved conversions of repatriated export proceeds, supported by the strengthening of monitoring mechanism of export proceed repatriation and conversion.

Accordingly, the exchange rate remains broadly stable within the market guidance that commenced from mid-May 2022, while the gap between the curb market and official exchange rates has declined notably in recent weeks, and such gap is expected to remain narrow in the period ahead with the improvements in the liquidity conditions in domestic foreign exchange market.

Meanwhile, reflecting the impact of improved forex liquidity and securing of sizeable financing assistance, the availability and distribution of essential commodities, such as fuel, cooking gas, medicine, fertiliser etc., have notably improved.

Arrangements are in place to secure continuous supply of such essential commodities in the period ahead. Gross official reserves, as at end July 2022, are estimated at US dollars 1.8 billion, including the swap facility from the People’s Bank of China equivalent to around US dollars 1.5 billion, which is subject to conditionalities on usability.

Negotiations with the IMF towards reaching a staff-level agreement on the Extended Fund Facility (EFF) arrangement are scheduled in coming weeks, while expeditious measures are being taken to advance the debt restructuring process with the assistance of financial and legal advisors.

Market interest rates have increased further in response to tight monetary and liquidity conditions

Reflecting the transmission of significant monetary policy tightening measures introduced thus far by the Central Bank, market interest rates have increased notably amidst tight money market liquidity conditions.

Growth of credit to the private sector is on a declining trend. The year-on-year growth of credit granted to the private sector slowed down notably in June 2022, with a contraction in absolute terms over the previous month, reflecting the impact of significantly high effective market interest rates and moderation of economic activity. Net foreign assets of the banking system continued to contract, weighing down the expansion of broad money supply.

With increasing interest rates, a notable deceleration in the growth of credit to the private sector and broad money supply is expected in the period ahead. Monetary financing has reduced notably in August 2022, while the need for further monetary financing is expected to be low in the period ahead, supported by fiscal consolidation measures that have already been introduced, alongside the implementation of cost-reflective pricing by major state-owned-business enterprises. Meanwhile, currency in circulation, which remains large, is returning to the banking system with the high deposit interest rates prevailing at present.

The pace of acceleration of inflation has moderated faster than expected

Headline inflation rose at a slow pace in July 2022, compared to recent months. Such moderation is expected to continue in the period ahead, thereby resulting in a low level of inflation by end 2022, compared to previous projections. Accordingly, the latest near term forecast of headline inflation shows a faster deceleration, compared to the previous monetary policy review, mainly due to downward revisions to administered prices and their second-round impact, together with the moderation in certain food prices and the stability in the exchange rate. With subdued aggregate demand pressures resulting from tight monetary and fiscal conditions, expected improvements in domestic supply conditions along with the anticipated normalisation in global food and other commodity prices, and the favourable statistical base effect, headline inflation is expected to moderate going forward, and is projected to stabilise in the desired range over the medium term.
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